Three recent events increase the difficulty of tax planning in the area of transfer pricing. First, the Omnibus Budget Reconciliation Act of 1993 (OBRA '93) amended IRC Sec. 6662 to give the IRS more ammunition in transfer pricing cases. IRC Sec. 6662 provides for accuracy-related and fraud penalties in a number of situations, including substantial valuation misstatements due to transfer price adjustments. On February 2, 1994, the IRS published temporary regulations to implement the strengthened accuracy-related penalties. These regulations are effective for taxable years beginning after December 31, 1993.

Second, on July 1, 1994, the IRS filed final transfer pricing regulations with the Federal Register. These regulations interpret IRC Sec. 482, which gives the IRS the authority to allocate taxable income across entities under common control to clearly reflect the income of the entities. The 1994 regulations are effective for tax years beginning after October 6, 1994, and replace temporary regulations that were issued in January 1993. Taxpayers have the option to apply the final IRC Sec. 482 transfer pricing regulations prior to their effective date. Because the final regulations tend to be more flexible and generally consistent with the temporary regulations they replace, it is anticipated many taxpayers will elect to implement the final transfer pricing regulations before the effective date.

Finally, on July 5, 1994, the IRS issued amendments to the IRC Sec. 6662 regulations to bring them into closer conformity with the final IRC Sec. 482 regulations. Although the IRC Sec. 6662 penalty regulations were just recently amended, the regulations, as amended, retain their original effective date, tax years beginning after December 31, 1993.

IRe Sec. 482 Transfer Price Regulations

Arm's-Length Character. Regulations under IRC Sec. 482 continue to apply an arm's-length standard to transactions between taxpayers under common control. Such taxpayers are usually referred to as "related parties" even though they may or may not be related as defined in the IRC. While the arm's-length character of controlled transactions is tested through comparison with comparable uncontrolled transactions, it is recognized that uncontrolled taxpayers that engage in comparable transactions under comparable circumstances do not always achieve identical results. The IRS will not allocate taxable income where results are within an arm's- length range. The final regulations provide extensive guidance on the determination of what such a range might be. For example, when the comparability of prices is somewhat unreliable, the interquartile of the range of possible prices will be considered to be the arm's-length range.

Best-Method Rule. The final regulations require that taxpayers determine transfer prices using the "best method." The best method is the one that provides the most reliable measure of an arm's-length result given the facts and circumstances of the transaction. Implementation of the best- method rule requires that taxpayers use one of six methods for a controlled transfer of tangible property and one of four methods for intangible property. The methods for tangible property are 1) the comparable uncontrolled price method, 2) the resale price method, 3) the cost-plus method, 4) the comparable profits method, 5) the profit-split method, and 6) unspecified methods. The methods for intangible property are 1) the comparable uncontrolled transaction method, 2) the comparable profits method, 3) the profit-split method, and 4) unspecified methods.

The regulations discuss each of the specified methods in detail and list comparability and reliability factors that should be considered under each of the specified methods.

The transfer pricing regulations provide considerable guidance on the application of the best-method rule. Implementation of the rule effectively requires taxpayers to evaluate all potential transfer pricing methods in spite of the statement in the regulations stating that "an arm's-length result may be determined under any method without establishing the inapplicability of another method." Although taxpayers will likely perform extensive transfer price analysis to comply with the regulations under IRC Sec. 482, it is the IRC Sec. 6662 accuracy-related penalty regulations that govern the type of documentation the taxpayers must prepare and retain.

Compliance with the transfer pricing regulations will not necessarily be sufficient to avoid accuracy-related penalties. The accuracy-related penalty regulations specify what taxpayers need to do to avoid penalties if an adjustment is made despite having paid careful attention to the transfer pricing regulations. Therefore, taxpayers should look to the IRC Sec. 6662 penalty regulations to determine what documentation is necessary to support a transfer price.

IRC Sec. 6662 and Accuracy-Related Penalty Regulations

There are two accuracy-related penalties under IRC Sec. 6662 associated with underpayment of tax attributable to incorrect transfer prices: a "transactional" penalty and a "net adjustment" penalty. No transactional penalty is assessed on a IRC Sec. 482 adjustment if the requirements regarding reasonable cause and good faith are met. The reasonable cause exception is defined in IRC Sec. 6664(c)(1) which states, "no penalty shall be imposed under this part with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion." Under amended IRC Sec. 6662 and the new related regulations, however, that same IRC Sec. 482 adjustment will be included in the amount subject to a net adjustment penalty unless it meets one of two safe harbors or if the amount is attributable solely to foreign corporations and U.S. tax liabilities are not affected.

Transactional Penalty. The transactional penalty applies to valuation misstatements that result from transfer prices that fall outside a corridor and also result in all underpayment of tax. A 20% transactional penalty applies in the case of a substantial valuation misstatement, i.e., if the transfer price is 200% or more (or 50% or less) than the amount determined trader IRC Sec. 482 to be the correct price. For example, if the correct transfer price is determined to be $10.00, a 20% penalty may apply if the taxpayer's transfer price is $5.00 or less or $20.00 or more. A gross valuation misstatement occurs and a 40% penalty may apply if the price is 400% or more or 25% or less than the correct price.

Net Adjustment Penalty. The net adjustment penalty applies if the net IRC Sec. 482 transfer price adjustments for the year exceed certain thresholds. Unless a taxpayer has satisfied requirements that allow an amount to be excluded, all transfer price adjustments are netted to determine whether a net adjustment penalty applies. Thus, amounts that have been already subject to the transactional penalty, as well as those where no transactional penalty has been assessed, are summed to determine the net transfer price adjustment.

If the net adjustment exceeds certain thresholds, a penalty applies. The thresholds were lowered by OBRA '93. The net adjustment penalty is 20% in the case of a substantial valuation adjustment that exceeds the lesser of $5 million or 10% of gross receipts. The penalty is increased to 40% in the case of a gross valuation net adjustment that exceeds the lesser of $20 million or 20% of the taxpayer's gross receipts. The regulations provide for coordination of the penalties so that the maximum penalty to apply to any one amount does not exceed 40%. For example, if an adjustment is already subject to a gross transactional penalty of 40%, that amount will not be subject to the net adjustment penalty. However, such amount will be included in the calculation of the net adjustment for purposes of determining whether the net transfer price adjustment exceeds the thresholds.

An Illustration

The extent of the burden placed on taxpayers and the potential cost of failing to satisfy transfer pricing and related penalty provisions is best illustrated with an example. A fictitious taxpayer is created but realistic data are used to evaluate its position.

Drug Co. USA produces Compound X, a base component of many common antibiotics. Compound X is used in a variety of final products sold under the company's label. While compound X is sold to unrelated distributors, most is sold to offshore affiliates for worldwide production and distribution. The affiliates are located in several countries.

The price the U.S. manufacturer charges its foreign affiliates is determined through independent negotiations with each affiliate. The affiliates are free to purchase Compound X from independent producers but are discouraged from doing so through a fixed-fee charged by Drug Co. USA for the privilege of an uninterrupted supply. The supplier and each purchaser bring information regarding uncontrolled transactions to the negotiations. This data is incorporated into the transfer price. As a result of these negotiations, the following transfers are made to affiliates in the indicated countries.

CountryPriceQuantity

A$43.00240,000

B80.0040,000

C55.0060,000

D10.002,000,000

Upon audit, the IRS accepts all transfer prices as reasonable except for the transfer to Country D. For a transfer of this quantity to this location, the IRS determines the arm's-length range of prices is from $12.50 to $28.50. Although the IRS can propose an adjustment to any point in the arm's-length range, a IRC Sec. 482 adjustment is proposed to the midpoint, i.e., $20.50. The adjustment results in an increase in U.S. source gross receipts and taxable income of $21 million ($10.50 per unit x 2 million units).

Assume the taxpayer is able to demonstrate it exercised reasonable cause and good faith when setting transfer prices and the IRS agrees not to assess the "transactional" penalty. Since a specified transfer pricing method (comparable uncontrolled price) was used, the taxpayer is confident the price is appropriate and within the provisions of IRC Sec. 482; therefore, the taxpayer did not negate alternative methods or prepare contemporaneous documentation other than that prepared at the time of the negotiations.

Although the taxpayer may have satisfied the provisions of IRC Sec. 482, an adjustment is still proposed. If upheld, this adjustment will cause a 40% gross valuation net adjustment penalty to be assessed. Thus, the total amount due to IRS as a result of the $21 million transfer price adjustment will be $11.113 million or more than 50% of the increase in U.S. taxable income. The calculations follow:

IncreaseinU.S.tax

liabilityduetoIRC

Sec.482adjustment

($21millionx35%).$7,350,000

Transactionalpenalty

notassessedbecause

ofgoodfaith-0-

Grossvaluationnet

adjustmentpenaltyof

40%oftheunderstatement

($7.35millionx40%)2,940,000

Estimatedinterest823,000

$11,113,000

Avoiding the Net Adjustment Penalty

OBRA '93 not only lowered the thresholds of the net adjustments penalty, but also changed the conditions under which the penalty can be avoided. Having reasonable cause for the transfer price is not enough. Now when calculating the amount subject to the net adjustment penalty, a transfer price adjustment can be disregarded only if the taxpayer satisfies one of two safe harbors. Both safe harbors require contemporaneous documentation that is more extensive than what might be prepared in complying with the new IRC Sec. 482 transfer pricing regulations.

The Specified Method

The specified method safe harbor requires the taxpayer to a) use a method specified in the transfer pricing regulations or bona fide cost- sharing arrangements and b) meet certain documentation requirements. The choice and application of the method must be reasonable and follow the principles of the best-method rule.

The new penalty regulations issued to implement OBRA '93, however, reinforce the best-method rule by stating, "A taxpayer can reasonably conclude that a specified method provided the most reliable measure of an arm's-length result only if it has made a reasonable effort to evaluate the potential applicability of the other specified methods." Thus, the analysis performed to identify the best method must be extensive, and the conclusion reached by the taxpayer after having conducted such analysis must be reasonable. Factors relevant to determining reasonableness include a) the experience and knowledge of the taxpayer, b) the extent to which accurate data were available and whether the data was analyzed in a reasonable manner, c) the extent to which the taxpayer followed the transfer pricing regulations, d) the extent to which the taxpayer relied upon an expert, and e) whether the taxpayer arbitrarily selected a result that corresponds to an extreme point in the range of results derived from uncontrolled comparables. The specified method safe harbor also requires the taxpayer to prepare certain principal, background, and tax return documents delineated in the regulations. The following is a list of such documents:

* Principal documents. The following principal documents that should accurately and completely describe the basic transfer pricing analysis conducted by the taxpayer:

- An overview of the taxpayer's business, including an analysis of the economic and legal factors that affect the pricing of its property or services;

- A description of the taxpayer's organizational structure (including an organization chart) covering all related parties engaged in transactions potentially relevant under IRC Sec. 482, including foreign affiliates whose transactions directly or indirectly affect the pricing of property or services in the U.S.;

- Any documentation explicitly required by the regulation under IRC Sec. 482;

- A description of the method selected and an explanation of why that method was selected;

- A description of the alternative methods that were considered and an explanation of why they were not selected;

- A description of the controlled transactions (including the terms of sale) and any internal data used to analyze those transactions;

- A description of the comparables that were used, how comparability was evaluated, and what (if any) adjustments were made;

- An explanation of the economic analysis and projections relied upon in developing the method; and

- A general index of the principal and background documents and a description of the recordkeeping system used for cataloging and accessing those documents.

* Background documents. Documents that support the assumption, conclusions, and positions contained in the principal documents.

* Tax return documents. If a taxpayer applies a profit-split method, or if the consideration for the controlled transfer of an intangible is in the form of a lump-sum payment, the taxpayer must attach a statement to the tax return that discloses the use of such method or payment and supporting calculations.

The documentation must be in existence when the return is filed and it must be sufficient to document that the taxpayer followed the best- method role. These documents must be supplied to the IRS within 30 days of request.

Required documents go beyond what a taxpayer would ordinarily prepare for compliance purposes. For example, while a taxpayer is generally not expected to prepare an overview of its business when filing its tax return, it may be reasonable to expect the IRS to request such an overview during an audit. The penalty provisions effectively require taxpayers to prepare documents, at the time it files its return, that the IRS might find helpful if the return is selected for audit.

Unspecified Method

The unspecified method safe-harbor documentation requirements are more or less stringent depending upon whether a specified method is or is not potentially applicable. If a specified method exists for a transaction, then a taxpayer must reasonably conclude that, given the available data, none of the specified methods was likely to provide a reliable result, and that it selected and applied an unspecified method in a way that would likely provide a reliable measure of an arm's-length result. If none of the methods specified under IRC Sec. 482 are applicable to a transaction, then a taxpayer must select and apply an unspecified method in a reasonable manner under the best-method rule. Again, the analysis performed to identify the best method must be thorough and well- documented.

What Taxpayers Should Do

The first step taxpayers should take in response to the recent changes in the transfer pricing and related penalty provisions is to estimate potential exposure and decide upon the level of comfort to be sought. If exposure is high, the best course of action may be to enter into an advance pricing agreement, or APA, with the IRS. Until now, many taxpayers have chosen not to pursue an APA because of the extensive analysis, documentation, and testimony that may be involved in securing the agreement. Now that extensive documentation is required to avoid the net adjustment penalty, the benefit of an APA is likely to outweigh any incremental cost. This avenue, however, might not be desired or possible because of the uniqueness and complexity of the transactions involved.

Taxpayers that engage in material transfers of goods or services across entities should, at a minimum, perform a transfer-pricing analysis. The analysis should be well documented and automated so that background documents are routinely gathered, catalogued, and input into the primary principal document - the transfer price analysis. For example, transfer- prices may be a function of projected sales and exchange rates. Projections may, in turn, depend upon economic variables for the locations involved (background information). The regulations require taxpayers to continuously search for information and to adjust transfer prices when conditions change. It is imperative that all departments involved in setting transfer prices know the potential tax ramifications if procedural changes are not implemented. Transfer prices may be set for managerial purposes so long as adjustments needed to comply with IRC Sec. 482 are made for tax purposes.

The Risk Is High

Installing a transfer-pricing system that meets the documentation requirements of the net adjustment penalty regulations is a difficult, yet necessary, task. The IRS audit and litigation record is expected to improve with the ability to obtain extensive transfer-pricing information within 30 days of its request. The penalty provisions, therefore, increase the expected cost of transfer-price adjustments in two ways. First, the penalty is more likely to apply when reasonable cause and good faith are not enough to avoid it. Second, the IRS is more likely to have its proposed adjustment upheld when it is able to use extensive taxpayer documentation to calculate the adjustment. The risk of not complying with the transfer pricing and related penalty provisions is high.

Sharon S. Lassar, PhD, is an assistant professor of accounting and Terrance R. Skantz, PhD, CPA, an associate professor of accounting, at Florida Atlantic University.