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Comments on transfer pricing penalty under Section 6662(e).

On February 28, 1991, the Internal Revenue Service issued proposed regulations under sections 6662 and 6664 of the Internal Revenue Code, concerning the accuracy-related penalty for substantial understatements of income tax, for negligence or disregard of rules and regulations, and for substantial valuation misstatements. The proposed regulations (IA-015-90) were published in the Federal Register on March 4, 1991 (56 Fed. Reg. 8959), and in the April 1, 1991, issue of the Internal Revenue Bulletin (1991-13 I.R.B. 24). (1) A public hearing was held on June 3, 1991. TEI submitted written documents on May 13, 1991, and testified at the public hearing. Regulations concerning transactions between persons described in section 482 and net section 482 transfer price adjustments were reserved under Prop. Reg. [subsection] 1.6662-5(j) and 1.6664-4(d) and are the subject of a separate regulation project (IA-035-91). In connection with that project TEI is pleased to submit these comments to supplement its original submission on section 6664(c)'s reasonable-cause and good-faith exception (hereinafter, "reasonable-cause exception") to imposition of the accuracy-related penalties.


Tax Executives Institute is the principal association of corporate tax executives in North America. Our nearly 4,700 members represent approximately 2,000 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.

TEI members 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 sections 6662 and 6664 of the Code and, in particular, the application of the reasonable-cause exception to the imposition of penalties for valuation misstatements in connection with net section 482 adjustments.

General Principles

The Internal Revenue Code imposes a penalty of 20 percent of the amount of any understatement of tax attributable, among other things, to "substantial valuation misstatements" as defined in section 6662(e). (2) As part of the Omnibus Budget Reconciliation Act of 1990, Congress extended the substantial valuation misstatement penalty to understatements of tax attributable to "net section 482 transfer price adjustments" that exceed certain thresholds. The penalty under new section 6662(e) will be imposed either (1) when transfer price adjustments in any one taxable year exceed $10 million dollars, or (2) when the transfer price or adjusted basis for property or services 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), the amount of the penalty is increased to 40 percent of the understatement of tax if there is a "gross valuation misstatement." A gross valuation misstatement is determined by substituting "$20 million" for "$10 million," "400 percent" for "200 percent," and "25 percent" for "50 percent."

Under section 6664(c) of the Code, the section 6662 penalty does not apply to any portion of an understatement (including understatements attributable to net section 482 adjustments) if the taxpayer had reasonable cause for the position taken and acted in good faith with respect to that position. Furthermore, under section 6662(e)(3)(B)(i), in determining whether the $10 million or $20 million thresholds are exceeded, a section 482 adjustment will be disregarded to the extent that the taxpayer can demonstrate reasonable cause and good faith in setting the transfer price.

The determination of "correct" transfer prices between related parties is an inherently factual undertaking. IRS examinations of intercompany pricing have resulted in intense and protracted litigation battles with taxpayers. Recent court cases under section 482 contain factual summaries and opinions that compete with 19th century Russian novels--or, perhaps, Satanic Verses -- in length (and, some might argue, lack of perspicuity.) Regardless of one's view of the outcome of transfer price cases, the court cases invariably demonstrate that highly trained, renowned economists can disagree substantially on the appropriate pricing method in a particular factual setting. That is to say, there is never a single, unassailable "right" answer. In an area such as transfer pricing, where "20/20 hindsight" is often applied by IRS examiners, TEI believes that the reasonable-cause exception should be interpreted to mitigate the severe underpayment penalty that may result from second-guessing a taxpayer's analysis and interpretation of complex factual data. In other words, we believe the section 6662(e) penalty should apply only in limited circumstances to instances of demonstrable culpability. (3) Such an approach would be consistent with the thrust of penalty reform.

In revamping the Internal Revenue Code's penalty regime in 1989, Congress recognized that penalties were being unevenly and unfairly assessed under old section 6661. (4) Penalties are intended to encourage compliant behavior and to punish taxpayer misconduct. Penalties can have a salutary effect on deterring proscribed behavior, however, only where the proper (or improper) course of conduct is known in advance. As Prop. Reg. [section] 1.6664-4(b) itself acknowledges, the most important factor to be considered in applying the reasonable-cause exception is the extent of the taxpayer's effort to self-assess his proper tax liability. Because the arm's-length standard is so fact driven, however, the absolute "correctness" of a transfer price may be impossible to determine with certainty in advance and, therefore, it may be impossible to fairly gauge the taxpayer's efforts to self-assess. (5) Indeed, the IRS and Treasury Department's White Paper succinctly describes the conundrum taxpayers (and the IRS) face in adhering to the "standard" of arm's-length pricing for related-party sales:

One of the most consistent criticisms of the section 482 regulations is that they do not provide taxpayers with enough certainty to establish intercompany prices that will satisfy the Service without overpaying taxes. Based on the government's experience in litigation, the current section 482 regulations also fail to provide the Service and the courts with sufficiently precise rules to make appropriate section 482 adjustments, especially when third party comparables are not available. . . . (6)

In other words, absent a properly construed reasonable-cause exception, section 6662(e) will wrong-headedly penalize behavior that cannot be known to be culpable. Indeed, we hope it was recognition of this fact that led the Treasury Department to oppose the effort to graft an ad hoc section 482 penalty onto the integrated understatement penalty reform of 1989. n7 TEI submits that the section 482 penalty violates fundamental principles of what penalties should and should not be. (8) Imposing a penalty where the standard of conduct is unknown or unknowable will unduly and unfairly raise the stakes for taxpayers in pricing disputes without advancing the fundamental goal of increasing compliance. Consequently, TEI urges the IRS and Treasury Department to recommend repeal of section 6662(e) in the report they are to submit to Congress on various measures to "improve compliance" with section 482. (9) (The report is to be filled no later than March 1, 1992.)

Absent repeal of section 6662(e), the potential for serious misuse of the penalty demands that specific guidance to taxpayers and IRS field personnel be issued as expeditiously as possible on the reasonable-cause exception. (10) The proposed regulations under section 6664 define reasonable-cause and good-faith conduct in very broad and general terms: it is a facts-and-circumstances determination to be made on a case-by-case basis. As previously noted, Prop. Reg. [section] 1.6664-4(b) provides that "the most important factor is the extent of the taxpayer's effort to assess the . . . proper tax liability." TEI recommends that specific guidance on the reasonable-cause exception take the form of safe harbors or presumptions of good-faith taxpayer conduct that will preclude assertion of the penalty. For example, guidance should be given on the type of conduct necessary to demonstrate that tax evasion or avoidance was not a purpose in the determination of the transfer price used. Otherwise, the penalty might be arbitrarily and inconsistently asserted or, far worse, be routinely and automatically asserted with every proposed section 482 adjustment exceeding the monetary threshold. (11)

To assist the IRS in promulgating specific guidance on the reasonable-cause exception under sections 6662(e) and 6664(c), TEI suggests below possible safe harbors of good-faith taxpayer conduct. Objective safe harbors and presumptions are useful to taxpayers and the government alike because they provide precise criteria that can be interpreted and applied uniformly. The proposals represent alternative methods of establishing "reasonable cause" such that satisfaction of any one of them negates the penalty. (12)

In addition, the regulations should provide a general rule that the section 482 penalty will not apply unless an objective standard for determination of the transfer price in the particular circumstances of the taxpayer exists at the time that the transaction occurs. In any event, we urge the IRS to issue an announcement that the section 482 penalty will not be applied until issuance of final "post-White Paper" regulations under section 482. (13)

Finally, in developing the reasonable-cause standard, TEI urges the IRS to recognize the conceptual tension between the United States and other jurisdictions -- especially treaty partners -- concerning the definition and interpretation of "arm's-length" pricing. In applying the penalty, the IRS should take into account that taxpayers are forced to deal with and reconcile the differing and sometimes conflicting pricing standards as well as varied interpreations of the "same" standard.

Amended Returns and Correction

of Errors by the Taxpayer

The reasonable-cause standard should be deemed met for the amount of any timely, voluntary, self-assessed adjustment. Where a taxpayer voluntarily self-assesses a net section 482 adjustment by filing an amended tax return, brings an adjustment to the attention of an IRS agent during an examination, (14) or otherwise corrects an error through its normal accounting procedures, no penalty under section 6662(e) should be assessed. Penalties are intended to encourage compliance. TEI believes that self-assessment upon discovery of errors is evidence of good-faith compliance that should negate the section 6662(e) penalty. 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, the penalty should not be asserted -- even if the IRS determines on examination that the adjustment should have been made in the earlier year.

De Minimis Threshold

Based on the Level of

Intercompany Transactions

TEI recommends that the regulations provide that reasonable cause and good faith will be deemed to exist where total net section 482 adjustments are insubstantial (say, 10 percent or less) in relation to the value of the taxpayer's total gross intercompany transactions subject to scrutiny under section 482. Such a provision would permit relief where the per-unit price deviation from the redetermined market price is relatively small, but the unit volume of intercompany transactions is quite large. Thus, even though the total adjustments to taxable income may exceed the $10-million threshold in section 6662(e)(1)(B)(ii), the penalty should not be asserted where the value of the related-party transactions are more than 10 times the adjustment amount.

TEI believes a de minimis rule is necessary in light of the size and multitude of intercompany transactions that must be monitored for compliance with section 482. The regulations should be drafted with an appreciation of the magnitude of the compliance burden that companies have already undertaken in the area of section 482. We note that the IRS has recognized the magnitude of the compliance burden for corporate taxpayers with an appropriate "90-percent" reasonable-cause exception in other areas. In particular, Treas. Reg. [section] 301.6651-1(c)(4)(ii) provides a reasonable-cause exception for failure to timely pay all of the tax due for a taxable year at the regular due date if the tax shown on Form 7004, or the amount of tax paid before the regular due date of a return, is at least 90 percent of the amount of tax shown on the taxpayer's Form 1120. We believe that the reasonable-cause exception to the section 6665(a) underpayment penalty is a sensible safe harbor and that its principle should be incorporated into proposed regulations under sections 6662(e)(3)(B)(i) and 6664(c). Thus, where the section 482 adjustment is less than 10 percent of the value of intercompany transactions subject to section 482 scrutiny, the taxpayer should be deemed to have met the reasonable-cause exception because it achieved substantial compliance in an area that the IRS and Treasury acknowledge is impossible to achieve with precision.

Absence of Tax Avoidance


The reasonable-cause exception should apply if the taxpayer has no demonstrable tax avoidance purpose in setting the transfer price. (15) Thus, reasonable cause and good faith should be deemed to exist where a transaction does not significantly reduce either the taxpayer's U.S. tax liability or the aggregate worldwide tax liability of the U.S. taxpayer and its foreign affiliates. For example, the regulations could import the principles underlying section 954(b)(4) to provide that no penalty will be asserted where the taxpayer can establish that its payment to a related foreign affiliate is "subject to an effective rate of income tax [in the hands of the affiliate] by a foreign country greater than 90 percent of the maximum rate of tax specified in section 11 of the Code." A reciprocal rule would have to be established in respect of payments received by a U.S. taxpayer. Alternatively, a reasonable-cause exception can be crafted that requires total combined U.S. and foreign taxes before adjustment to be at least 90 percent of combined U.S. and foreign taxes after the net section 482 adjustment.

Since the United States has concluded tax treaties with its principal trading parties and these countries generally have high tax rates, a safe harbor should exist where the transaction is with a related party in a country whose tax treaty with the United States provides a competent authority procedure. Where competent authority procedures are available, the U.S. taxpayer and its foreign affiliate are stakeholders to the allocation of taxable profits between the U.S. and foreign government. The price used in the intercompany transaction should be presumed to have been established with reasonable-cause and good-faith reliance upon the ability of the respective governments to allocate taxable profits in accordance with the respective pricing standards. The IRS could issue a revenue procedure setting forth the circumstances where, notwithstanding the existence of competent authority procedures, the presumption of reasonable cause will not apply.

In lieu of the foregoing, the regulations could provide that the section 482 penalty will be asserted only in respect of transactions with related parties in a list of specified low-tax countries. The listing of such countries could be set forth in an annual revenue procedure.

Reliance on Prior Audit Result

TEI recommends that reasonable cause should be presumed if the taxpayer can demonstrate that it relied upon the result reached in a prior IRS audit settlement in establishing its transfer prices. Thus, 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 should be presumed to have acted in good faith and with reasonable cause. Reliance is established where the taxpayer can show that a transaction or group of transactions was examined through the issuance of specific Information Document Requests, even though no adjustment was proposed. For example, if documentation for an intercompany loan was requested in a previous examination and no adjustment was proposed (or one was proposed but subsequently withdrawn or settled), the taxpayer should be presumed to satisfy the reasonable-cause exception if the loan is continued on the same terms (or is modified to comport with the settlement). Another example of a potentially long-term agreement that straddles multiple tax periods and IRS audit cycles is a bona-fide cost-sharing agreement. The taxpayer should be presumed to have met the reasonable-cause standard in relying upon the acceptance of the cost-sharing agreement by the IRS and thereby avoid the penalty where, after a period of years, a cost contribution or other related items are adjusted.

As to sales of tangible personal property, we believe the exception should apply as long as the pricing methodology, product line, and commercial sales volume are consistent. The foreign affiliate involved in a prior examination should not have to be identical. As a matter of administrative convenience, a taxpayer should be able, if it so desires, to use a consistent transfer pricing method for all affiliates and transactions involving similar product lines.

Adequate Documentation

of Pricing Policy

In the White Paper, the IRS and Treasury Department reported that the IRS had experienced considerable difficulty establishing the transfer pricing policy actually used by taxpayers. The lack of contemporaneous documentation of pricing led, in the IRS's view, to audit delays and ex post facto justification of the pricing policy. Given this viewpoint, we believe it is appropriate to create a presumption in favor of taxpayers that do create and maintain adequate transfer pricing documentation. Thus, a taxpayer should be entitled to a presumption of reasonable cause and good faith in its pricing policy where it can show that it has adopted a business pricing policy designed to establish arm's-length prices between related parties, produces on examination contemporaneous documentation showing how the transfer price was set, and can verify that the business policy was in fact followed. Moreover, if the taxpayer used comparables, either exact or inexact, in setting its transfer prices and produces contemporaneous documentation that the comparables established the basis for intercompany prices, no penalty would be imposed. If comparables were not available, then a reasonably detailed description of the methodology employed to establish prices would have to be produced for the taxpayer to fall within the safe harbor.

Reliance on Foreign

Tax Jurisdiction

Foreign tax authorities in non tax-haven countries have a legitimate and compelling interest in transfer price arrangements involving affiliates of U.S. companies. A taxpayer faced with an "arm's-length" standard for pricing on both sides of a transaction cannot blithely ignore that the foreign government will require its "fair share" of taxable profit. The "independent" influence exerted by the foreign jurisdiction will, in and of itself, temper the likelihood of a tax avoidance transaction between related parties. Consequently, if a taxpayer engages in an intercompany transaction with an affiliate in a country with an arm's-length standard for related party transactions, the price charged should be presumed to satisfy the good-faith and reasonable-cause standard. Similarly, if the taxpayer establishes that the foreign jurisdiction has accepted the transfer price as arm's length, the presumption of reasonable cause and good faith would be met.

Independent Experts

The current section 482 regulations rely heavily on finding comparable goods, services, and intangibles to determine whether an arm's-length price has been used. Where comparables exist, application of the regulations is straightforward. Where no comparables can be found or where similar items are only distantly comparable, the regulations leave the IRS and taxpayers with little guidance. (16) As a result, taxpayers often engage independent experts -- accountants, lawyers, economists, engineers, scientists, appraisers, et al. -- to assist in the determination of an arm's-length price.

Prop. Reg. [section] 1.6664-4(b)(1) states "[r]eliance . . . on the advice of a professional (such as an appraiser, attorney, or accountant) does not necessarily demonstrate reasonable cause and good faith." TEI believes the operative word in the proposed regulations is necessarily. We do not quarrel with the rule insofar as it is cautionary advice that not all "experts" are qualified for a particular task and it would not be reasonable for a taxpayer to rely upon any adviser with professional accreditation. Nevertheless, we believe that, as long as the professional is established as competent in the field (whether through experience, study, or training), a taxpayer should be able to rely upon the professional's opinion that the arm's-length standard has been met. Reasonable experts may reasonably disagree on the construction of an arm's-length price for products, services, or intangibles for which comparables are unavailable. Taxpayers should not be penalized simply because the IRS's expert's view prevails over the taxpayer's adviser. Thus, unless the taxpayer's ability to rely on the independent expert is demonstrably compromised (e.g., by evidence of collusion), the taxpayer should be deemed to have met the reasonable-cause exception.

Industry Statistics and

Operating Results

Taxpayers and the IRS often use industry statistics to establish comparability of prices by comparing gross profit margins, markup percentages, return on assets, and similar financial ratios. Although the courts generally have not adopted these comparisons as a legal standard for determining whether an arm's-length price was charged, TEI believes that a results-oriented approach provides an objective standard to measure a taxpayer's reasonableness and good faith for purposes of the section 6662(e) penalty. Thus, we recommend adoption of a presumption that reasonable cause and good faith will be found if the taxpayer either (1) relied upon published industry statistics in establishing the transfer price used, or (2) actually achieved financial results on intercompany transactions that were consistent, within a reasonable range, with results achieved by independent parties.


Tax Executives Institute appreciates this opportunity to present our views on the proposed regulations relating to the reasonable-cause exception for imposition of the substantial underpayment penalties for net section 482 adjustments under sections 6662(e) and 6664(c) of the Code. If you have any questions concerning these comments, please do not hesitate to call Raymond G. Rossi, chair of TEI's International Tax Committee, at (408) 765-1193 or Jeffery P. Rasmussen of the Institute's professional tax staff at (202) 638-5601.

(1) For simplicity's sake, the proposed regulations are referred to as the "proposed regulations"; specific provisions are cited as "Prop. Reg. [section]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.

(2) I.R.C. [subsection] 6662(a); 6662(b)(2).

(3) The regulatory standards for determining arm's-length pricing are in a state of flux owing to the uncertainty engendered by the Tax Reform Act of 1986 and the subsequent Treasury Department Section 482 "White Paper." See The Section 482 White Paper: A Study on Intercompany Pricing (A Department of the Treasury and Internal Revenue Service Discussion Draft) (October 18, 1988) (hereinafter, the "White Paper"). The White Paper in particular has clouded the issue of determining comparables because of its emphasis on, in effect, a contract-manufacturing approach -- an emphasis on the "cost-plus" method that is at odds with the pricing methods in the current regulations and that the courts have consistently refused to embrace.

(4) H.R. Rep. No. 101-247, 101st Cong., 1st Sess. 1393 (1989) (hereinafter, the "House Report").

(5) Taxpayers and the IRS may never agree on the precise arm's-length price in particular cases, except perhaps with respect to commodity-type transactions where price quotations are readily available, or where safe harbors are provided in the section 482 regulations (e.g., interest rates on loans), or where the taxpayer and the IRS enter into an advance pricing agreement in accordance with Rev. Proc. 91-22, 1991-22 I.R.B. 11.

(6) White Paper at 73.

(7) Testimony of Kenneth W. Gideon, Assistant Secretary of the Treasury for Tax Policy, reprinted in Hearings on Tax Underpayments by U.S. Subsidiaries of Foreign Companies Before the Subcommittee on Oversight of the House Committee on Ways and Means, 101st Cong., 2d Sess., July 10 and 12, 1990.

(8) See IRS Commissioner's Executive Task Force, Report on Civil Penalties (1989), reprinted in BNA's Daily Tax Report No. 35 (Feb. 23, 1989)(Special Supplement). For a detailed, principle-by-principle ananlysis see D. Wickman, The New U.S. Transfer Pricing Tax Penalty: A Solution or a Symptom of the Cause of the International Transfer Pricing Puzzle, to be printed in 18 International Tax Journal 1 (Winter 1991). The principles as distilled by Mr. Wickham are: "(1) a penalty should not be retroactive; (2) a penalty should not be used to raise revenue; (3) a penalty should reinforce and be rationally related to a standard of behavior which exists in the law and which is stated clearly in [comprehensive terms]; (4) a penalty should be effective; (5) a penalty should be fair and should be perceived to be fair; (6) the amount of a penalty should be perceived to be fair and reasonable and nor disproportionate to the culpability of the conduct in question; and (7) a penalty should be readily administrable in the sense (a) that it will be imposed when it should be and not when it should not be, (b) that it not be so excessively severe as to make it difficult to impose, and (c) that demands made by its enforcement . . . will not divert [IRS] resources from more important objects."

(9) See [section] 11316, Omnibus Budget Reconciliation Act of 1990.

(10) The reasonable-cause exception will operate optimally to restore a rational relationship between culpable behavior and the imposition of a penalty. Therefore, statements by Treasury officials that leaving the definition of "reasonable cause" to be developed by the courts are troubling. See J. Turro & L. Sheppard, ABA Tax Section Conference: Summer Avalanche of International Regs Forecast, 51 Tax Notes 960, 962 (May 27, 1991). Unless the reasonable-cause exception is fleshed-out, taxpayers will be compelled to overpay their taxes to avoid the risk of a penalty. See the portion of the White Paper quoted on page [415], supra.

(11) In 1989, Congress railed against the "routine," "automatic," and "mechanical" assertion of penalties. House Report at 1393, 1405. The same danger exists under section 6662(e) where after examining "all the facts and circumstances" and determining a transfer price to be incorrect, a revenue agent may conclude that, ipso facto, the taxpayer lacked reasonable cause and good faith for establishing the price used. Without appropriate regulatory safeguards, revenue agents could invoke the in terrorem threat of penalties to extract a settlement favorable to the government on the underlying transfer price issue.

(12) The proposed safe harbors and presumptions are intended to mitigate only the assertion of the penalty, not to vitiate the pricing adjustment itself.

(13) The negligence and fraud penalties, however, would continue to be available in the interim to combat egregious taxpayer behavior.

(14) The IRS has previously sanctioned this type of approach to avoid the substantial understatement penalty. See Rev. Proc. 85-26, 1985-1 C.B. 580.

(15) Section 482 empowers the IRS to make adjustments where necessary (1) to prevent tax avoidance and (2) to clearly reflect income. TEI believes that section 6662(e) should be construed to apply only in avoidance situations. Thus, the regulations should recognize that while 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 a demonstrable tax avoidance purpose.
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Publication:Tax Executive
Date:Nov 1, 1991
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