IRS emphasizes the importance of solid, compliant transfer pricing documentation in new FAQs
On April 14, 2020, the IRS released a list of frequently asked questions (FAQs) on transfer pricing documentation and the net adjustment penalty. The FAQs highlight that taxpayers that do not have fully compliant transfer pricing documentation in place when their U.S. tax returns are filed face increased risk of penalties.
The FAQs were released in response to an IRS Large Business & International division directive and an IRS Advisory Council suggestion to educate taxpayers on how to improve their transfer pricing documentation, and are based on the IRS’s views of best practices and errors made by taxpayers during the preparation of that documentation. The IRS says they are intended to create a more cooperative effort by taxpayers in complying properly with transfer pricing documentation regulations.
If there is a material valuation misstatement regarding a taxpayer’s transfer pricing, penalties could be imposed per Internal Revenue Code (IRC) Section 6662(e). The FAQs focus on one of the types of penalties that can apply when there is an underpayment of tax due to an improper valuation for transfer pricing purposes: the “net adjustment penalty” described in Section 6662(e)(1)(B)(ii). Generally, if the dollar thresholds of the net adjustment penalty are met, a taxpayer can avoid the penalty only if the taxpayer has accurately completed the transfer pricing documentation requirements of Section 6662(e)(3)(B) and Treas. Reg. Section 1.6662-6.
The principal documents that taxpayers must prepare to comply with the transfer pricing requirement are found in Treas. Reg. Section 1.6662-6(d)(2)(iii)(B). Yet, complying with the requirements for 6662(e) documentation does not automatically mean a taxpayer will not face penalties. It must also be concluded that the documentation was prepared in an accurate and reasonable manner. Accordingly, the new FAQs seek to inform taxpayers and to incentivize them to improve the quality of their documentation.
The FAQs explain that by preparing transfer pricing documentation that shows a thorough review and assessment of the selection and application of the best transfer pricing method, taxpayers will decrease their compliance risk and their chances of having their transfer pricing flagged for ongoing examination. High-quality documentation will lead an examining agent to rely on the taxpayer’s assessment of functions, assets, and risks for the parties involved and will make the review process more efficient in the examination of transfer pricing issues that are deemed to be low-risk. Therefore, it is imperative that taxpayers have strong and accurately prepared transfer pricing documentation.
The IRS strives to confirm that taxpayers prepare transfer pricing documentation and analyses that adhere to Section 482 and the regulations thereunder. The arm’s length standard states that for a related party transaction, the transfer prices charged and income generated must be based on prices that would have been charged by unrelated parties under similar conditions. Based on the arm’s length principle, taxpayers must select the best method that allows them to test the related party prices charged during the year for an intercompany transaction. The method selected must show that the results that arose during the year would have occurred if unrelated parties had been part of these transactions.
Clearly, transfer pricing continues to be a significant risk area for multinational taxpayers. The latest FAQs issued by the IRS highlight the need for taxpayers to have robust transfer pricing documentation to manage these risks. Oftentimes, preparing such documentation will lead to planning opportunities.
For more information, visit our International Tax Practice webpage.
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