Temporary and proposed transfer pricing penalty regulations.

On June 2, 1994, Tax Executives Institute filed the following comments on proposed and temporary r sections 6662(e), 6662(h), and 6664(c) of the Internal Revenue Code, relating to the imposition of t for substantial and gross misstatements attributable to section 482 allocations. TEIS comments were aegis of its International Tax Committee, whose chair is Lisa Norton of the Ingersoll-Rand Company. materially to the preparation of the comments were Robert L. Ashby of Northern Telecom Inc., Stephen McDonald's Corporation, and Mark R. Gilmour of the Aluminum Company of America.

On January 27, 1994, the Internal Revenue Service issued temporary and re-proposed regulations under sections 6662(e), 6662(h), and 6664(c) 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. (At the same time, the IRS withdrew the proposed regulations that had been issued on January 21, 1993.) The new regulations were published in the Federal Register on January 27, 1994 (59 Fed. Reg. 4791, 4876), and in the Internal Revenue Bulletin on March 7, 1994 (1994-10 I.R.B. 6, 20).

For simplicity's sake, the most recent temporary and proposed regulations are referred to as the "temporary regulations" and the prior proposed regulations are referred to as the '1993 proposed regulations." Specific provisions are cited as "Temp. Reg. [sections]" or "Prop. Reg. [sections]." References to page numbers are to the temporary 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 approximately 5,000 members represent 3,000 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 temporary regulations under sections 6662(e), 6662(h), and 6664(c) of the Code, relating to the imposition of the accuracy-related penalty for substantial and gross valuation misstatements attributable to section 482 allocations.

General Comments

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 so-called section 482 penalty is to be imposed either (i) when the transfer price adjustments in any one taxable year exceed the lesser of $5 million or 10 percent of the taxpayer's gross receipts,(1) 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.(2) Under section 6662(h), the 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 20 percent of the taxpayer's gross receipts), or 400 percent or more (or 25 percent or less) of the "correct" transfer price.

Last year, Congress adopted several changes to the net adjustment penalty. Section 13236 of the Omnibus Reconciliation Act of 1993 (OBRA) replaced the reasonable cause standard for avoiding the penalty under old law with a codification of the contemporaneous documentation requirements set forth in the 1993 proposed regulations.(3) Under the OBRA changes to section 6662(e)(3)(b), the penalty does not apply to any portion of the understatement if--

(i) the taxpayer determines its

         transfer prices in accordance
         with a specific method set
         forth in the section 482 regulations
         (a "specified method");

(ii) the taxpayer has documentation

         as of the time its return
         is filed that sets forth the determination
         of its prices in
         accordance with the specified
         method and that establishes
         the use of that method was
         reasonable; and

(iii) the taxpayer provides such

          documentation to the Secretary
          of the Treasury within
          30 days of a request.

A taxpayer not using a specified method may avoid the penalty if it satisfies the requirements in subsections (ii) and (iii) above and further establishes that (a) none of the specified methods was likely to have resulted in a price that clearly reflected income and (b) the non-specified method was likely to have resulted in such a price.(4)

In many respects, the temporary regulations represent a much-needed improvement over the 1993 proposed regulations. For example, the temporary regulations provide that a transfer pricing study from a prior year may be reasonably relied upon in a later year if the relevant facts or circumstances have not changed or if the study or analysis has been appropriately modified to reflect any change in facts and circumstances.(5) TEI recommended this practical approach in its comments on the 1993 proposed regulations and we commend the IRS for including the concept in the temporary regulations. We are also pleased with the clarification that the failure to make all the required adjustments under a specified method will not throw the taxpayer into an unspecified method, as well as the IRS's withdrawal of the more-likely-than-not standard. These changes will assuage taxpayer apprehensions concerning the potential for arbitrary imposition of the penalty.

TEI also applauds the IRS for attempting to provide taxpayers with specific guidance regarding the scope of the required documentation. In our comments on the 1993 proposed regulations, we recommended that the final regulations provide guidance on what constitutes adequate documentation. We regret, however, that the resulting list of documents in the temporary regulations includes certain items that are unnecessary to effective auditing of transfer prices and, as such, impose an undue burden on taxpayers.

We find other aspects of the temporary regulations puzzling--not so much for what they provide, but for what they fail to provide. In spite of public statements by Treasury and IRS officials that the IRS possesses the authority under the statute not to apply the section 482 penalty(6), the temporary regulations effectively accord no discretion to the district director to forgo asserting the penalty, or even to extend the time in which the required documents must be produced. The absence of such discretion contrasts significantly with the broad latitude granted the district director in other areas. See, e.g., Consolidated Penalty Handbook [sections] (20)333.8 (issued July 1992) (district director may abate penalties where a taxpayer relied on erroneous oral advice from IRS). See also Treas. Reg. [subsections] 1.6038A3(e) (and (f) (district director may enter into agreements concerning records retention and may extend time for production); Treas. Reg. [sections] 1.6038A-6(f) (district director may deem reporting corporation as complying with agent authorization requirements).

TEI believes that the regulations should expressly address the use of discretion in administering section 6662(e). Providing such discretion would permit implementation of Congress's mandate to improve the IRS's administration of section 482 and to meet its obligation under section 7805(a) to provide "all needful rules and regulations for the enforcement of [the Code]." Recognizing the IRS's discretionary authority to administer section 6662(e) would foster the overarching policy consideration of tax administration: fairness. Failure to respect this policy could well impede voluntary compliance. It would also undermine Congress's unambiguous decision that penalties should not be automatically imposed. See H.R. Rep. No. 101-247, 101st Cong., 2d Sess. 1393 (1989) (The Ways and Means Committee is concerned that the present-law accuracy-related penalties "have been determined too routinely and automatically by the IRS.... The Committee believes that [amending the accuracy-related penalty provisions] ... will lead to greater fairness of the penalty structure.").

TEI acknowledges that the statutory language of section 6662(e) is susceptible to multiple interpretations, some more taxpayer-adverse than others. We urge the IRS to confirm--in both the regulations and its penalty handbook--that the assertion of penalties requires the exercise of discretion and judgment. If the transfer pricing penalty is imposed automatically, it will (almost by definition) be imposed arbitrarily. We continue to believe that penalties should be fault-driven. If imposition of the section 482 penalty becomes mechanical, the principle of fairness that animated penalty reform in 1989--and virtually every public utterance by senior IRS officials on the philosophy of penalty administration since then--will be significantly undermined. The final regulations should recognize the district director's discretion to waive the penalty in appropriate circumstances.

Preamble: Reliance on APAs and the Results of Prior Audits

The preamble to the temporary regulations states that if a transfer pricing methodology is developed and applied pursuant to an advance pricing agreement (APA), that methodology may be reasonably relied upon in the current year if the relevant facts and circumstances have not changed or if the methodology has been appropriately modified to reflect any such changes. 1994-10 I.R.B. at 9. The temporary regulations themselves, however, are silent concerning the effect of an APA on the applicability of section 6662(e).

TEI recommends that the IRS expressly provide--in the regulations--that a taxpayer who in good faith voluntarily obtains an APA will ordinarily not be subject to a penalty, at least where the taxpayer files an annual report demonstrating that 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.(7) We do not understand the IRS's reluctance to fashion such a regulatory presumption. The legislative history of the 1993 amendments to the penalty reflects Congress's clear intent that these amendments include a delegation of authority to the IRS not only to waive the penalty in cases where the taxpayer relies on an APA, but also in circumstances where there is prior audit experience:

Another reason that might be

relevant in some cases [not

to apply the penalty] would

be the prior development by

the IRS and the taxpayer,

after a thorough review of the

factors that account for a

clear reflection of income under

the particular circumstances

that pertain to a

particular taxpayer, of a particular

agreed unspecified

method. Such a method may

be embodied, for example, in

an advance pricing agreement.

H.R. Rep. No. 103-111, 103d Cong., 1st Sess. 722 (1993) (Report of the Committee on the Budget) (emphasis added).(8) Reliance on prior audit experience results becomes more reasonable in the context of a taxpayer that is under continual audit and subject to scrutiny as part of the IRS's Coordinated Examination Program (CEP).

TEI believes that the regulations should encourage reliance on APAs or prior audit agreements to resolve transfer pricing disputes. Thus, we recommend that, 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 by the IRS--either through an APA or prior audit agreement--should not be subject to a penalty.(9)

Temp. Reg. [sections] 1.6662-6T(d)(2)(ii): Specified Method Requirement

A. Taxpayer's Experience and Knowledge. Temp. Reg. [sections] 1.6662-6T(d)(2)(ii) sets forth rules for the selection of a specified method. The temporary regulations provide that the taxpayer's selection and application of a specified method is reasonable only if the taxpayer reasonably concluded that the method provided the most accurate measure of an arm's-length result under the best method rule of the substantive section 482 regulations. A specified method must provide a more accurate result than any other specified method.

Whether a taxpayer's conclusion was reasonable is determined under a facts-and-circumstances test. One of the factors to be considered is the experience and knowledge of the taxpayer, including all members of the taxpayer's controlled group.(10) The temporary regulations essentially hold all members of a controlled group to the highest standard applicable to any member of the group.

TEI believes that the regulation is overbroad. Temp. Reg. [sections] 1.6662-6T(a)(3) provides that the terms used in the temporary regulations shall have the same meaning as identical terms used in the section 482 regulations. Temp. Reg. [sections] 1.482-1T(g)(6), in turn, defines controlled group as "taxpayers owned or controlled directly or indirectly by the same interest." The term is thus not limited to members of the consolidated group and encompasses distinct (and possibly foreign) entities and joint ventures. Casting such a wide net could exceed the scope of the statute, which bases the imposition of the penalty on the taxpayer's behavior.

Moreover, TEI believes that imputing the expertise of one corporate member to another is unduly harsh. Not all members of a corporate group will necessarily possess the same level of knowledge and experience. This is particularly true for large multinational groups of corporations engaged in distinct lines of business, and for foreign-owned multinational corporations that may have minimal access to their parent companies' tax compliance policies.

TEI recommends that the reference to that taxpayer's controlled group be deleted and the taxpayer's knowledge and experience be judged on a company-by-company basis. Thus, if Subsidiary A manufactures widgets and Subsidiary B produces microchips, A's knowledge of the widget market should not be imputed to B. At a minimum, the imposition of the penalty should turn only on the knowledge and experience of the members of the consolidated group.(11)

B. Collection of Data. Temp. Reg. [sections] 1.6662-6T(d)(2)(ii)(B) provides that the taxpayer must engage in a "reasonably thorough" search for the data necessary to determine which method should be selected and how it should be applied. The temporary regulations further provide that "the expense of collecting data relative to the dollar amount of the transactions in question is a factor that may be taken into account in determining the scope of a reasonably thorough search for data." The preamble offers an example whereby the taxpayer does not need to obtain data regarding a comparable uncontrolled transaction if the intercompany transaction had a value of $50,000 and the search would cost $25,000. The taxpayer would, however, be expected to expend (at least) that amount if it engaged in intercompany transactions with a value of $250 million. 1994-10 I.R.B. at 8.

TEI commends the IRS for recognizing that a cost-benefit analysis may be a factor in determining whether the taxpayer has made a "reasonably thorough" search for data. We suggest, however, that the use of a range--especially such a broad range of .01 percent vs. 50 percent--is fraught with difficulties. A cost of even 10 percent of the value of the transactions could well wipe out the profit margin on a product. The example will undoubtedly lead to arbitrary decision making. TEI believes that the regulations should emphasize the taxpayer's efforts to comply with the law. We recommend that the regulations provide that taxpayers will be expected to incur costs that are reasonable under the circumstances.

Temp. Reg. [subsections] 1.6662-6T(d)(2) (3): Documentation Requirements

A. Principal Documents. Temp. Reg. [subsections] 1.6662-6T(d)(2)(iii)(B) and (3)(iii)(A) provide the requirements for documentation of the taxpayer's method for establishing its transfer pricing. The temporary regulations divide the types of documents into two categories: principal documents and background documents. The preamble states that the documentation requirement "does not provide a long, rigid list of documents that must be maintained," but rather focuses on the type of information necessary to evaluate the taxpayer's choice of method. 1994-10 I.R.B. at 9. In contrast, Temp. Reg. [sections] 1.6662-6T(d)(2)(iii)(B) delineates nine documents that "must" be included within the definition of "principal documents." The principal documents are: (1) an overview of the taxpayer's business; (2) a description of that taxpayer's organization structure; (3) documentation required under the substantive section 482 regulations; (4) a description of the specified method selected and why it was selected; (5) a description of the unspecified methods that were considered and why they were rejected; (6) a description of the controlled transactions; (7) a description of the comparables; (8) an explanation of the economic analysis and projections relied upon in developing the method; and (9) an index of the principal and background documents. The list thus includes not only documents relating to a description of the methodology used, but also educational material relating to an overview of the taxpayer's business.

TEI believes that providing a list of documents to be maintained is helpful to taxpayers; we also agree with the statement in the preamble that the regulations should not provide a "long, rigid" list. In its discussion of the background documents required to be maintained, the temporary regulations recognize that not all the documents referred to in the regulations (including the regulations under section 6038A) need to be maintained in all circumstances.(12) TEI recommends that similar cautionary language be included in the regulations dealing with principal documents. The required documentation should be limited to those items necessary to provide an examining agent with the data necessary to make a determination concerning whether a taxpayer's conclusions were reasonable and whether further investigation is warranted.

With respect to the proposed requirement of a description of unspecified methods that were considered (item 5 of the foregoing list), we understand that the provision was intended to require documentation concerning the specified, rather than unspecified, methods that were rejected by the taxpayer. Even if the requirement is so circumscribed, we believe it is improper to require taxpayers to maintain and provide documentation with respect to rejected specified methods. Under Temp. Reg. [sections] 1. 482-1T(b)(2)(iii), a taxpayer is not required to analyze its transfer prices under alternative methods in order to satisfy the best method rule. Requiring such documentation for purposes of avoiding the section 482 penalty imposes a higher burden than that required under the substantive regulations and, hence, compels taxpayers to provide documentation showing analyses under all potentially relevant specified methods. The requirement--whether relating to the documentation of specified or unspecified methods--should be eliminated.

Items 1, 2, and 9 essentially require the taxpayer to assist the examining agent in accessing and digesting the specified data. The temporary regulations thus go substantially beyond specifying record "maintenance" to record "creation." We believe it is improper to require the creation of specific educational material in advance under the threat of a penalty. Requiring a taxpayer to create documents is beyond the scope of the recordkeeping requirements of section 6001. Rather than listing these items as mandatory, the documents could be described as helpful in supporting a taxpayer's transfer pricing methodology.

Finally, we urge the IRS to continue the effort to provide more specific guidance to taxpayers, while preserving flexibility. As the IRS gains more experience with documentation developed in particular industries through the APA process, additional guidance could be published, perhaps in the form of a revenue procedure, setting forth document recommendations for specific categories of taxpayers or transactions.

B. Discretion to Extend the 30-Day Period. Temp. Reg. [subsections] 1.6662-6T(d)(2)(iii)(A) and (3)(iii)(A) include the requirement that the taxpayer must produce such documentation within 30 days of an IRS request. The temporary regulations further provide that the district director may, in his discretion, excuse a "minor or inadvertent" failure to provide the required documents, but only if the tax-payer has made a good faith effort to comply and promptly remedies the failure when it becomes known.

TEI believes that the discretion given the district director to recognize mitigating circumstances in respect of the section 482 penalty is too narrow. Even where a taxpayer complies with the contemporaneous documentation requirements, it may take some time to produce the supporting material. The documents may be in storage or overseas. In these circumstances, we suggest that the district director be given the discretion to grant reasonable extensions of time to produce the documents. In addition, the regulations should clarify that the failure to produce background documents within 30 days will not normally result in the assertion of a penalty where the taxpayer makes a good faith effort to comply within that time period.

Temp. Reg. [subsections] 1.6662-6T(a)(2) (d)(2): Results Reported on a Return

Temp. Reg. [sections[ 1.6662-6T(a)(2) provides that whether an underpayment is attributable to a substantial misstatement must be determined from the results of controlled transactions that are reported on an income tax return, regardless of whether the amount reported differs from the transaction price initially reflected in the taxpayer's books. The results of controlled transactions that are reported on a qualified amended return will be used only if the amended return is filed before the IRS has contacted the taxpayer regarding the original return.

Although Temp. Reg. [sections] 1.6662-6T(a)(2) clearly contemplates that the penalty may be averted by the filing of a qualified amended return, Temp. Reg. [sections] 1.6662-6T(d)(2)(ii)(B) provides that a taxpayer must use the most current reliable data available "before the return is filed"--an ambiguous reference that leaves doubt whether it concerns the original or amended return.(13) It makes no sense to penalize a taxpayer who in good faith files an amended return. Indeed, such activities should be encouraged. Nothing in the statute bars the IRS from recognizing that documentation may include information reflected in an amended return. The final regulations should provide that a taxpayer that files an amended return showing an adjustment that exceeds the threshold will not be subject to the penalty where the taxpayer produces documentation that supports the results reported on the amended return.

Finally, the temporary regulations are ambiguous concerning the effect of data discovered after the transaction is completed but before the return is filed. For example, a comparable may not exist at the time of the transaction, but may arise after the end of the taxable year and before the return is filed. Regardless of whether an adjustment may be sustained in respect of such prices, we do not believe that a penalty should be imposed in these circumstances.

Conclusion

Tax Executives Institute appreciates this opportunity to present the foregoing views on the temporary regulations under sections 6662(e), 6662(h), and 6664(c) 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) This penalty is referred to as a "net adjustment penalty" in the temporary regulations. Temp. Reg. [sections] 1.6662-6T(c)(1). (2) This penalty is referred to as the "transactional penalty" in the temporary regulations. Temp. Reg. [sections] 1.6662-6T(b)(1). (3) The standard for waiving the transactional penalty was not changed by OBRA. The penalty may be waived if the taxpayer establishes it acted with reasonable cause and in good faith. (4) OBRA did not change section 6662(e)s "foreign-to-foreign" exclusion, which provides that any increase in taxable income attributable to a controlled transaction between two foreign corporations is excluded from the calculation of a net income adjustment, unless the treatment affects the determination of either corporation's taxable income from sources within the United States or from income effectively connected with the conduct of a U.S. trade or business. (5) Temp. Reg. [sections] 1.6662-6T(d)(2)(ii)(D). (6) See, e.g., Treasury Official Says IRS Has Discretion In Applying Transfer Pricing Penalty, 175 BNA Daily Tax Report G-9 (Sept. 13, 1993). (7) The statement in the preamble, while laudable, is of dubious benefit to taxpayers, since there is virtually no authoritative guidance concerning the status of preambles to regulations. But see Armco, Inc. v. Commissioner, 87 T.C. 865, 868 (1986) (dicta) ("A preamble will frequently express the intended effect of some part of a regulation. As a statement of intent that represents an institutional viewpoint, such a document might be helpful in interpreting an ambiguity in a regulation."). (8) The House report discusses the taxpayer's reliance on an APA in the context of the use of an unspecified method. Although taxpayers will more likely seek an APA for approval for the use of an unspecified method, there is no policy justification for precluding taxpayers from relying on an APA in respect of a specified method. (9) With respect to an APA, a material change would be defined by reference to the critical assumptions reflected in the agreement. (10) The other factors are (i) the extent to which accurate data were available and analyzed in a reasonable manner; (ii) the extent to which the substantive section 482 requirements were followed; and (iii) the extent to which a taxpayer reasonably relied on an economic study. (11) This alternative would be consistent with the manner in which the proposed regulations test whether the penalty thresholds have been exceeded. See Temp. Reg. [subsections] 1.6662-6T(a)(2), (a)(7), Examples 3, 4, & 5. (12) Temp. Reg. [sections] 1.6662-6T(d)(2)(iii)(C). (13) See also Temp. Reg. [sections] 1.6662-6T(d)(2)(iii)(A), which provides that the documentation must be in existence when the return is filed.