Transfer pricing penalty pitfalls.

Temporary regulations under Sec. 6662 (as updated by the Revenue Reconciliation Act of 1993) have been issued by the IRS to replace the 1993 proposed regulations and provide guidance for the accuracy-related penalties relating to the Sec. 482 intercompany pricing rules. These penalties have the power to hit unsuspecting taxpayers (small start-up operations and billion dollar multinationals alike) with penalties of up to 40% of the underpayment of tax as determined by the Service.

A 20% penalty is imposed on "substantial" transfer pricing valuation misstatements, which occur if the price claimed on an income tax return for any property or service transferred between related parties is 200% or more (or 50% or less) of the amount determined to be the correct price under Sec. 482 (the "transactional penalty"). The 20% penalty is also triggered if a Sec. 482 adjustment for the tax year exceeds the lesser of $5 million or 10% of the taxpayer's gross receipts (the "net adjustment penalty"). The penalty imposed is doubled to 40% for "gross" transfer pricing valuation misstatements that occur if the price claimed on an income tax return for any property or service transferred between related parties is 400% or more (or 25% or less) of the amount determined to be the correct price under Sec. 482, or if the net Sec. 482 adjustment exceeds the lesser of $20 million or 20% of the taxpayer's gross receipts. Taxpayers must consider that the 40% penalty will apply in the following common scenarios.

Example: A U.S. parent (P) owns 100% of a foreign manufacturing and distributing subsidiary (F).

* Scenario 1: F uses P's name in the course of marketing its product, without compensating P with royalty payments. The IRS determines F should be paying P a royalty of $200,000 for the value of P's name. The 40% penalty is applicable even though the adjustment is small; adjusting from zero to any number exceeds the gross valuation misstatement threshold.

* Scenario 2: P purchases replacement or spare parts for its specialized manufacturing equipment and holds them for future needs. To better service foreign customers, P transfers a portion of them to F at cost, totaling $50,000. Under Sec. 482, the Service determines the fair market value of these specialized parts is $200,000 and adjusts P's taxable income to reflect $150,000 gain on the sale.

* Scenario 3: P's marketing department has developed a program that has proven to be very effective in marketing its products in all geographic regions. P assists F in the implementation of this program, but does not receive any compensation from F. The IRS determines that the marketing know-how and assistance given to F should have resulted in $200,000 of income to P, and adjusts P's taxable income accordingly. (This type of adjustment could also result from bookkeeping, treasury, internal audit services, etc.)

* Scenario 4: P has developed an inventory-tracking software program that has cut down on the company's inventory obsolescence. P requires F to use the software in its warehouses, but does not charge F for it. Under Sec. 482, the Service determines that P's taxable income should be increased by $100,000, which would have been charged in an arm's-length transaction.

* Scenario 5: F, in its course of expansion, has obtained financing from unrelated financial institutions in its home country. Although F negotiated each of the loan agreements on its own, P has routinely guaranteed or cosigned the loans. The Service determines that P should be compensated for its services as guarantor of the indebtedness and adjusts its taxable income accordingly.

The 40% "transactional penalty" would be imposed in each of these scenarios, since the price claimed by P on its tax return was 25% or less than the IRS-adjusted amount.

There are two ways to avoid the imposition of these onerous penalties. First, the taxpayer could establish a supportable transfer pricing policy and determine arm's-length charges for each of these transactions. This will presumably avoid any IRS adjustments and, therefore, avoid penalties. Unfortunately, this is either impossible or impractical in many taxpayer situations. Second, the taxpayer could meet the exceptions provided in the new temporary regulations.

To avoid the "net adjustment penalty," a taxpayer must either select and apply a "specified method" in a reasonable manner or must "reasonably conclude" that no specified method accurately measures an arm's-length result. In addition, the taxpayer must maintain extensive "contemporaneous documentation," which must be in place when the return is filed and provided to the Service within 30 days of a request. To avoid the "transactional penalty," a taxpayer must either meet the standards mentioned above or satisfy the subjective "reasonable cause and good faith requirements" of Sec. 6664. The most important factor for reasonable cause is the extent of the taxpayer's effort to assess its proper tax liability. In the above scenarios, however, it would be difficult or impossible for a taxpayer to meet this exception.

In summary, it is important to consider exposure to 20% or 40% penalties and the related documentation and good faith requirements before engaging in any related party cross-border transactions, no matter how small.