Brian Yacker, Tax Manager, Rowbotham & Company
Published in the Asset Protection Journal (Winter 200)

For example, multi-national companies now find themselves required to satisfy substantive documentation requirements (e.g. preparing transfer pricing reports) in order to protect themselves from the severe transfer pricing penalties described herein. In the United States, these substantive transfer pricing documentation requirements apply to any multi-national companies, regardless of how small their business is.

The preparation of this contemporaneous transfer pricing documentation is usually very costly, potentially creating an expense that many multi-national businesses (especially start-ups or smaller businesses) simply cannot bear. Thus, many businesses are left with the Hobson’s Choice of being non-compliant with the United States transfer pricing rules, and as such, being liable for severe penalties, or being compliant with these rules and potentially bankrupting their business. The remainder of this article examines the penalties imposed by the United States for failure to comply with the United States transfer pricing rules and presents the requirements for compliance with the United States transfer pricing rules, so a business does not to fall prey to the transfer pricing penalties.

Briefly, in regards to United States transfer pricing rules, §482 of the Internal Revenue Code authorizes the IRS to allocate gross income, deductions, and credits between related parties to the extent necessary to prevent evasion of taxes or clearly to reflect the income of the related taxpayers. The §482 Regulations are based on the principle that transactions between related parties should be evaluated on an arm's-length basis.

Section 482 provides guidance for related parties in their determination of an appropriate arm's-length transfer price to be charged in their related-party transactions. Section 482 and the accompanying Regulations are necessary to prevent related taxpayers in different taxing jurisdictions from easily and artificially shifting items of income and expense between these different tax jurisdictions (with differing rates of tax).

Section 482 will usually be applicable in any situation where a United States entity enters into transactions (e.g. sales, loans, provision of management services) with a related foreign entity. The intent of §482 is to ensure that, from a United States tax perspective, an arm's-length price is charged in all related-party multi-jurisdictional transactions. Violation of §482 will lead to imposition of the penalties described immediately below.

Pursuant to §6662(e) and §6662(h) of the Internal Revenue Code, for those who violate the rules set forth in §482, there are two types of penalty thresholds which need to be considered; the valuational (transactional) threshold and the net §482 adjustment threshold. As described below, each penalty is computed at either 20% or 40% of the underpayment of tax as a result of a transfer pricing adjustment.

If the valuation of any transfer price is 200% greater or 50% or less of an arm's-length transfer price or if the net §482 adjustment for the particular taxable year exceeds the lesser of $5 million or 10% of the taxpayer’s gross receipts, then the penalty for exceeding the particular threshold is 20%. If the valuation of any transfer price is 400% greater or 25% or less of an arm's-length transfer price or if the net §482 adjustment for the particular taxable year exceeds the lesser of $20 million or 20% of the taxpayer’s gross receipts, then the penalty for exceeding the particular threshold is 40%.

Additionally, in regards to whether the 20% or the 40% penalty applies, the following needs to be considered:

• In cases where no transfer price was charged, then the 40% penalty will generally always apply
• Where no transfer pricing report was prepared, then the 40% penalty will generally always apply
• Where an incomplete transfer pricing report (e.g. a transfer pricing report omitting some of the required 10 steps) is prepared, it is uncertain whether the 20% or the 40% transfer pricing penalty will be applied

According to many transfer pricing commentators, the recent DHL Corp. v. Commissioner case (involving the reallocation of income between a delivery company and its Hong Kong affiliate) is the first transfer pricing case in which the United States Tax Court upheld a 40% transfer pricing penalty.

For United States transfer pricing purposes, the optimal way that a business can avoid imposition of the transfer pricing penalties is for them to apply for an Advance Pricing Agreement (“APA”). An APA is an agreement (essentially a contract) whereby the IRS and the multi-jurisdictional taxpayer agree on a transfer pricing methodology to be prospectively applied to an apportionment of income and deductions between the taxpayer and related parties in other taxing jurisdictions. An APA provides the taxpayer with the certainty that the IRS will not challenge its transfer pricing determination for a period of three to five years.

However, the standard APA procedures can be costly and time consuming, and as such, many small businesses probably cannot financially afford to avail themselves of the standard APA procedures. Accordingly, the IRS has recently developed particular APA procedures specifically applicable to small businesses. In such regard, the IRS has recently issued Notice 98-65, which sets forth special procedures applicable to small business taxpayers that are designed to facilitate the small business in obtaining an APA.

However, notwithstanding the fact that the stated objective of the small business APA program is to address concerns that the perceived costs to secure a standard APA are high in proportion to the size of the transactions involved, the costs to secure a small business APA can still be prohibitive for the small business which has just established operations or whose annual revenues are insignificant. As such, some taxpayers will decide to contemporaneously prepare a transfer pricing report (pursuant to Reg. §1.6662-6(d)(2)(iii)(B)) to prevent imposition of the transfer pricing penalties.

The preparation of transfer pricing reports can be very time consuming and costly and the taxpayer is not assured that their determined transfer price is a reasonable arm's-length price. As such, the taxpayer is still vulnerable to a transfer pricing audit by the IRS. However, if the transfer pricing report is prepared properly, it can prevent imposition of the penalties.