In 2018, the IRS reminded exam teams to perform a “diligent penalty analysis” in every transfer pricing case. Since then, we have observed that the agency is increasingly willing to impose penalties, even where reasonable minds differ as to the appropriate transfer pricing. Penalties are often raised late (at the very end of an audit or even after the dispute is in court) and can create an extra liability of hundreds of millions—or billions—of dollars. For all these reasons, it is worth your time to brush up on how these penalties work, as well as what you can do to defend against them.

Basic Mechanics. The Internal Revenue Code describes two types of transfer pricing penalties:

  • A “transactional” penalty, which applies if the taxpayer’s chosen price in a transaction is a certain percentage higher or lower than the IRS-determined “correct” price.
  • A “net adjustment” penalty, which applies if the net increase in taxable income from the transfer pricing adjustment exceeds a certain threshold, ignoring carryover tax attributes from other years, such as NOLs.

Each of these penalties can result in either a 20% or 40% increase in tax liability, depending on how “off” the taxpayer’s transfer pricing was from the IRS’s “correct” transfer pricing. Practically speaking, the IRS will typically assert the 40% net adjustment penalty, because it applies if the transfer pricing adjustment exceeds $20 million—a very low threshold. Sizeable penalties may complicate resolving transfer pricing issues with IRS Appeals, and all penalties have financial statement implications.

The IRS can also assert other “accuracy-related” penalties in transfer pricing cases. For example, in Western Digital, the IRS asserted the net adjustment penalty, as well as penalties for “negligence, “disregard of rules or regulations,” and “substantial understatement of income tax.” But, mercifully, these penalties do not “stack”: While the IRS can assert multiple penalties in the alternative, only the highest that is sustained ultimately applies.

Defenses. The only defense to the transfer pricing penalties is the “reasonable cause and good faith” defense. For the transactional penalty, the taxpayer can establish reasonable cause and good faith in a variety of ways (e.g., by showing the taxpayer’s reliance on outside advisors). For the net adjustment penalty—which, again, appears to be the IRS’s go-to penalty in transfer pricing cases—the taxpayer has only one way of proving reasonable cause and good faith. Specifically, within 30 days of a request, the taxpayer must provide the Internal Revenue Service with transfer pricing documentation that applies a reasonable transfer pricing method.

In all cases, it is therefore incumbent upon taxpayers to prepare good transfer pricing documentation (sometimes named “Section 6662 documentation” after the penalty statute in the Code). Although many taxpayers prepare documentation internally, taxpayers may want to consider whether for certain transactions, they should engage a competent advisor to prepare the documentation. While not necessary for the net adjustment penalty, this would provide enhanced penalty protection for the transactional penalty. Whether done internally or by an outside advisor, both the taxpayer and the advisor should study the detailed regulations that describe what the transfer pricing documentation must contain and the factors considered in determining the reasonableness of selecting and applying the taxpayer’s methodology. Although the documentation need only be produced upon request to avoid penalties, it must be prepared by the time the return is filed.

We have noticed an uptick in the IRS’s rejection of taxpayer’s Section 6662 documentation as being sufficient to avoid the imposition of penalties. For example, in the Western Digital case, the IRS asserted significant penalties, even though the taxpayer had provided the IRS with documentation prepared by a Big4 accounting firm.

Final Thoughts. At the same time that it instructed examiners to consider penalties in transfer pricing cases, the IRS also developed a procedure for examiners to change a taxpayer’s transfer pricing method in audit. Since 2018, such changes must go through a formal approval process within the IRS. We are aware of situations where the exam team has gone through the approval process to change a taxpayer’s transfer pricing method and has subsequently imposed penalties, rejecting the reasonableness and the adequacy of the taxpayer’s section 6662 documentation. The IRS’s guidance on penalties could be read to suggest that the examiner should assert penalties automatically if the examiner obtains approval to change the taxpayer’s method. Moreover, a 2018 update to the Internal Revenue Manual could be read to suggest automatic penalties if no section 6662 documentation is provided or if the documentation provided is “unreasonable or inadequate.” In line with this guidance, we have noticed more penalties being asserted in transfer pricing cases. Taxpayers would be well advised to revisit their transfer pricing documentation and (where appropriate) consult with a competent advisor.