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Intercompany transfer pricing penalties.

In view of the Clinton administration's stated goal of raising substantial tax revenues, it is clear that a perceived source of revenue is international companies. Intensified audit activity of intercompany transactions with related foreign parties has already been experienced.

Even foreign-owned companies not targeted for audit have received "Third Party Information Requests" from the Service for exhaustive relevant intercompany pricing data. This information is used by the IRS in auditing other taxpayers.

Newly issued temporary and

proposed regulations

On Jan. 13, 1993, the Service issued temporary and proposed regulations relating to intercompany transfer pricing, which liberalized and added more flexibility to the previous rules. However, the quid pro quo for this relief is contemporaneous documentation.

More significantly, to encourage compliance with these new rules, the sanction of severe penalties has been reinforced.

The new regulations, together with the severe penalties for non-compliance, require corporate tax departments to become more involved with transfer pricing decisions and at an earlier stage. Further, the assistance of tax professionals is inevitable to cut through these intricate rules and to demonstrate that the taxpayer acted with reasonable cause and in good faith in setting transfer prices.

As a practical matter, the rules will force taxpayers to examine and document transfer pricing policies before they file their tax returns.

What is at stake?

Typically, IRS adjustments related to intercompany pricing merely shifted income between countries and did not affect the total worldwide tax burden. However, these new penalties, which are not deductible for U.S. income tax purposes, provide great incentive for companies to - review their intercompany pricing policies; - establish sound methods within the new rules for such pricing; and - contemporaneously document these policies and methods.

Otherwise, an unprepared company may find itself involved in a prolonged and costly IRS audit.

Accuracy-related penalty

A penalty may be imposed if a transfer price adjustment exceeds $10 million or if a transfer price claimed on a income tax return is 200% or more, or 50% or less, of the correct price.

The penalty is 20% of the tax underpayment attributable to the intercompany pricing adjustment. However, no penalty is imposed unless the tax underpayment exceeds the greater of 10% of the required tax or $10,000 for a regular corporation ($5,000 for an S corporation, personal holding company or other taxpayer).

Gross overstatements

A 40% penalty applies to "gross" overstatements of 400% or more, or 25% or less, of the correct transfer price, or if there is a transfer price adjustment exceeding $20 million. The following example illustrates how quickly a taxpayer can be exposed to the 40% penalty.

Example: A taxpayer sells 200,000 widgets at $1,900 each in intercompany transactions totaling $380,000,000. The ITS adjusts the price of a widget from $1,900 to $2,005. Thus, total sales are now $401,000,000. Accordingly, the transfer price adjustment is $21,000,000 ($401,000,000 - $380,000,000). The 40% penalty could apply to the tax deficiency attributable to this $21,000,000 adjustment.

Exception to penalty

The new temporary pricing regulations were accompanied by new proposed accuracy-related penalty regulations that would provide relief from these penalties if a tax-payer acted with reasonable cause and in good faith.

To qualify, two tests must be met.

1. Reasonable effort: The taxpayer must show that a reasonable effort was made to accurately determine the transfer prices when the return was filed. Documentation must exist at that time and must include an analysis indicating that the result was arm's length. This documentation must be provided to the Service within 30 days of a request. 2. Reasonable belief: The taxpayer must show that, when the return was filed, the taxpayer reasonably believed that - the methodology produced an arm's-length result (reliance on the advice of, or a study done by, a professional is taken into account); and - the result would, more likely than not, be sustained on its merits.

Effective date

These proposed regulations would apply to tax years beginning after Apr. 21, 1993. The transfer pricing penalty was effective for tax years ending after Nov. 5, 1990. The Service considers the proposed regulations to be a reasonable interpretation of the standards for applying the penalty for years prior to the proposed regulations' effective date, except that no requirement for contemporaneous documentation may be imposed on past transactions. Taxpayers may elect to apply the proposed regulations retroactively.

Legislative proposal

The administration has proposed legislation that would codify the proposed penalty regulations, which would be effective for tax years beginning after 1993 and supplemented by a transfer pricing enforcement initiative.
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Article Details
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Author:Bruno, Erasmo S.
Publication:The Tax Adviser
Date:May 1, 1993
Previous Article:Passive foreign investment companies.
Next Article:Recent reporting and disclosure requirements may apply to certain nonresidents after 1991.

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