Transfer Pricing – General Principles, Penalties and Contemporaneous Documentation

General Principles – Transfer pricing is relevant for U.S. companies with foreign subsidiaries or foreign parent companies that engage in certain intercompany transactions.  U.S. transfer pricing rules require that intercompany pricing between a U.S. company and a foreign affiliate must be based on an ‘arm’s length’ price that would be charged in a similar transaction with an unrelated third party.  The arm’s length principle is typically applied to intercompany transactions in which goods, services or property are sold between a U.S. company and a foreign affiliate.  The transfer pricing rules also can apply to intercompany transactions in which payments for intercompany loans or payments for the use of property are transferred between a U.S. company and a foreign affiliate. 

U.S. transfer pricing is enforced under the authority of Internal Revenue Code Section 482 which allows the IRS to reallocate gross income, deductions or credits between two or more organizations, trades or businesses whether or not incorporated, organized in the United States or affiliated, which are owned or controlled directly or indirectly by the same interests in order to clearly reflect income or to prevent the evasion of taxes.

Penalties – The U.S. transfer pricing penalties are set forth under Internal Revenue Code Section 6662.  For a substantial valuation misstatement, the penalty is 20% of the underpayment of tax if an income tax return understates taxable income and reports a transfer price that is 200% or more or 50% or less of the amount determined under Section 482 to be the correct transfer price.  For a substantial valuation misstatement, the penalty is 20% of the underpayment of tax if the net Section 482 transfer price adjustment for the taxable year exceeds the lesser of $5 million or 10% of the taxpayer’s gross receipts.

For a gross valuation misstatement, the penalty is 40% of the underpayment of tax if an income tax return understates taxable income and reports a transfer price that is 400% or more or 25% or less of the amount determined under Section 482 to be the correct transfer price.  For a gross valuation misstatement, the penalty is 40% of the underpayment of tax if the net Section 482 transfer price adjustment for the taxable year exceeds the lesser of $20 million or 20% of the taxpayer’s gross receipts.

Contemporaneous Documentation – In an international tax audit, the IRS may impose transfer pricing penalties if intercompany pricing is above or below a certain benchmark range based on the arm’s length transfer pricing standard under Section 482 principles.  The IRS will allow a U.S. company to provide contemporaneous documentation to substantiate its transfer pricing methodology and policy to avoid transfer pricing penalties.  The contemporaneous documentation should be in the form of a transfer pricing tax opinion and must be in place for the tax year by the due date of the respective U.S. Federal tax return.

The IRS will not impose transfer pricing penalties after a transfer pricing adjustment under Section 482 if the taxpayer: (1) establishes that it was reasonable in using a method to determine its transfer prices under Section 482; (2) describes the method it used in determining its transfer prices in documentation that is in place by the due date of its tax return; and
(3) provides such documentation to the IRS within 30 days of request.

Be aware that reports such as the Schedule M of the Form 5471 are the first place that the IRS will look to identify intercompany transactions between the U.S. company and a foreign subsidiary corporation.

For further information, please contact your Aronson LLC tax advisor or Alison Dougherty, International Tax Services at 301.231.6290 for more information.