Transfer pricing studies still may be needed to comply with the sec. 482 regulations.

Sec. 6662 (e) was amended, effective for tax years beginning after 1993, increasing the possibility that improper intercompany prices (transfer prices) between related companies would be subject to penalties. Under the new rules (as implemented by final regulations under Sec. 482 and proposed regulations under Sec. 6662 (e), issued in July 1994, and by final and temporary regulations under Sec. 6662 (e), issued on Feb. 8, 1996), transfer prices that are too high or too low are subject to penalties equal to 20% or 40% of any tax understatement resulting from improper prices. However, these penalties can be avoided if the taxpayer demonstrates that it has met certain tests as to its choice of transfer pricing methods and the application of those methods, and has prepared appropriate documentation to support its transfer pricing. The regulations provide that a study prepared by a professional, a "transfer pricing study," is one factor to be considered in evaluating whether or not the IRS will assess penalties.

To comply with the regulations, a taxpayer must examine the various methods of pricing particular goods or services, choose the "best method" of pricing, apply the method properly and maintain documentation as to how the prices were derived. The documentation must exist at the time the taxpayer's tax return is filed and must be given to the IRS within 30 days after it is requested by the Service.

For calendar-year corporations, the new rules (as implemented by the final and proposed regulations issued in 1994) should have been followed for 1994 tax returns, which were due (with extensions) by Sept. 15, 1995. Ideally, taxpayers should have engaged professionals to perform a transfer pricing study and had documentation in place by that date to support the fact that prices complied with one of the pricing methods specified in the regulations. Corporations with fiscal years ending on or before Aug. 31, 1995 also should have complied with the new law and regulations. Corporations with fiscal years ending between Sept. 30, 1995 and Nov. 30, 1995 still have time to comply with the new law and regulations if they have not already done so.

This item deals with the following categories of taxpayers:

* Category A: Fiscal-year taxpayers who have not complied with the new transfer pricing and penalty regulations, but still have time to do so.

* Category B: Taxpayers who have already complied with the new transfer pricing and penalty regulations.

* Category C: Taxpayers who have already filed 1994 tax returns, but did not comply with the new transfer pricing and penalty regulations.

Cautions: Income tax accruals may be understated if the required documentation is absent, since the tax and penalty consequences of potential IRS transfer price adjustments may not be reflected.

Category A: Fiscal-Year Taxpayers Who Still Have Time to Comply

These taxpayers should realize that it is dangerous not to meet the pricing and documentation requirements. Even if the taxpayer's intercompany pricing appears to be reasonable, there are potentially significant penalties if the Service determines that the prices should be adjusted. If the pricing does not appear to be reasonable, a transfer pricing study is imperative, since it may be necessary to adjust prices to bring them into compliance with Sec. 482 and the regulations thereunder.

Category B: Taxpayers Who Complied With the Regulations in 1994

If a taxpayer had a transfer pricing study for 1994, and complied with the documentation requirements, a complete new study may not be necessary. However, it still will be necessary to update the 1994 study to make sure that there have not been substantial changes in the facts or numbers. Comparable transactions and/or companies should be rechecked, and statistical methods (such as the comparable profits method) should be recalculated. A company that was in compliance for 1994, but does not update its 1994 information, will not be in compliance for 1995.

An update of a 1994 transfer pricing study should be considerably less expensive than the original study.

Category C: Taxpayers Who Did Not Comply With the Regulations in 1994

Taxpayers who did not comply with the regulations for 1994 (they did not have a transfer pricing study and/or did not otherwise comply with the documentation requirements), and also fail to comply for 1995, will double their potential exposure to penalties. On the other hand, if they have a transfer pricing study performed for 1995, they will reduce their exposure for that year. If the study also looks at 1994 pricing, the taxpayer will not be protected from 1994 penalties, but it will be given an idea as to whether its 1994 pricing fits within one of the pricing methods specified in the regulations. If the 1994 pricing does not fit within one of the allowable methods, the taxpayer may wish to change its 1994 prices retroactively (if this is possible under the laws of the country in which the taxpayer's related company is located) to reduce its 1994 exposure.

Observations

The documentation requirements under the final regulations issued in 1996 are easier, to some extent, than under the proposed regulations issued in 1994. For example, under the proposed regulations, the taxpayer had to consider pricing information available until the date the return was filed, in determining whether pricing was acceptable under the methods prescribed by the Sec. 482 regulations. Under the final regulations, only information available at the end of the tax year must be considered. However, information available after the end of the year must be provided to the IRS on request. (Other requirements also have been somewhat relaxed, but are beyond the scope of this item.)

In any event, the final regulations do not reduce the need for a transfer pricing study. Without such a study, it may be difficult for a taxpayer to demonstrate that it has considered all allowable transfer pricing methods and chosen the best method.

The final regulations are effective Feb. 9, 1996. However, taxpayers may elect to apply them to all open tax years beginning after 1993.

(See also Tax Clinic, "Transfer Pricing Documentation for the Small and Mid-Size Company," TTA, Sept. 1995, p. 536.)