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U.S. Transfer Pricing Accuracy-
Related Tax Penalties

Internal Revenue Code §6662


Verse Consulting LLC
October 2009
Contents


•   Introduction
•   The Penalties
       Transactional Penalty
           Examples
           Reasonable Cause...
Introduction



• The U.S. Internal Revenue Code (IRC)
  p
  provides for nearly 150 p
                    y     penalty
 ...
Transactional Penalty


•   With respect to transfer pricing, the transactional penalty
    applies to individual transact...
Example: Transfer Pricing for Globalco


•   Globalco manufactures regular light fixtures at its U.S. plant and
    transf...
Example: Transfer Pricing for Globalco


•   In 2006, Globalco had a record year and sold 10 million regular
    fixtures ...
Example: Transfer Pricing for Globalco


•   2008 was a terrible year for Globalco. The company sold
    250,000 regular f...
Example: Transfer Pricing for Globalco


Penalty calculation
Number of fixtures sold                                     2...
Example: Transfer Pricing for Globalco


•   Globalco also manufactures premium light fixtures at its U.S.
    plant, whic...
Example: Transfer Pricing for Globalco


•   Penalty? Which one?
       Yes. Gross valuation misstatement.
           The ...
Reasonable Cause and Good Faith


•   If a company can show that there was reasonable cause for the
    underpayment and t...
Net Adjustment Penalty


•   With respect to transfer pricing, the net adjustment penalty is
    based on the sum of all i...
Exclusion from Net Adjustment Penalty


•   An amount is excluded from the calculation of a net §482 adjustment if
    the...
Exclusion from Net Adjustment Penalty


•   The documentation requirement is met if the taxpayer
    maintains documentati...
Example: Transfer Pricing for Globalco


•   Considering the same base facts in the foregoing examples,
    Globalco sold ...
Example: Transfer Pricing for Globalco


•   Globalco sold 8 million fixtures and reported $32 million of net
    income. ...
Setoff Allocation Rule


•   In cases in which the taxpayer may meet some but not all of the
    exclusions to the net adj...
Coordinating the Penalties


•   Under this penalty regime, it is entirely possible that a taxpayer
    could be assessed ...
Key Considerations for U.S.
                                             Multinationals

•   Two Penalties
         Transa...
Appendix: 10 Principle Documents
      Overview of the taxpayer’s business, including an analysis of the economic and lega...
Contact us



    Verse Consulting LLC
   1200 Smith Street, Suite 1600
         Houston, Texas 77002
          713-353-39...
The Fine Print


•   Not to be repurposed or sold.
•   This presentation is provided for information purposes only and
   ...
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U.S. Transfer Pricing Penalty Regime Summary

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Summary discussion of the U.S. accuracy-related tax penalties. Important information for companies with transfer pricing considerations.

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U.S. Transfer Pricing Penalty Regime Summary

  1. 1. U.S. Transfer Pricing Accuracy- Related Tax Penalties Internal Revenue Code §6662 Verse Consulting LLC October 2009
  2. 2. Contents • Introduction • The Penalties Transactional Penalty Examples Reasonable Cause and Good Faith Exception Net Adjustment Penalty Examples Exclusion from Net Adjustment Penalty Setoff Allocation Rule • Coordinating the Penalties • Key Considerations for U.S. Multinationals • Appendix: 10 P i i l D A di Principle Documents t
  3. 3. Introduction • The U.S. Internal Revenue Code (IRC) p provides for nearly 150 p y penalty y provisions. • With respect to transfer pricing the most important penalties to understand are those under IRC §6662 §6662.
  4. 4. Transactional Penalty • With respect to transfer pricing, the transactional penalty applies to individual transactions in which the transfer price is determined not to be arm’s length by the IRS. g y • Substantial vs. Gross Valuation Misstatement Substantial misstatement – Transfer price for a specific transaction is 200 percent or more (or 50 percent or less) of the correct price determined under §482. Penalty – 20 percent of the tax underpayment. Gross misstatement – Transfer price for a specific transaction is 400 percent or more (or 25 percent or less) of the correct price determined under section §482. Penalty – 40 percent of the tax underpayment underpayment.
  5. 5. Example: Transfer Pricing for Globalco • Globalco manufactures regular light fixtures at its U.S. plant and transfers them to its subsidiaries worldwide for distribution. Globalco reported income based upon a transfer price of $10 for each fixture. Globalco’s cost of goods sold (COGS) is $6 and it earns $4 gross profit per fixture.
  6. 6. Example: Transfer Pricing for Globalco • In 2006, Globalco had a record year and sold 10 million regular fixtures and reported $40 million of net income. On audit, the IRS determined that the transfer price per fixture should have been $13, increasing Globalco’s net income by $3 million. • Penalty? Which one? No penalty. Globalco would not be subject to the transactional penalty since the arm’s length transfer price assessed is arm s not greater than 200 percent (50 percent or less) of the intercompany transfer price.
  7. 7. Example: Transfer Pricing for Globalco • 2008 was a terrible year for Globalco. The company sold 250,000 regular fixtures and reported $1,000,000 of net income. On audit, the IRS determines that the price per fixture should have been $30. • Penalty? Which one? Yes. Substantial valuation misstatement. Globalco would face the 20 percent transactional penalty because the arm’s length transfer price assessed is arm s greater than 200 percent of the amount Globalco claimed on its return.
  8. 8. Example: Transfer Pricing for Globalco Penalty calculation Number of fixtures sold 25,000 Assessed Arm’s Length Price: $30 Less: Globalco’s COGS $6 Adjusted Net Income: 25,000 * $24 $600,000 Less: Reported Net Income ($100,000) Amount of Underpayment: $500,000 $500 000 Amount of Tax Underpayment (ETR=35%): 35% * $500,000 $175,000 Penalty (Substantial): 20% * $175,000 $35,000 Tax Underpayment + Penalty: $210,000
  9. 9. Example: Transfer Pricing for Globalco • Globalco also manufactures premium light fixtures at its U.S. plant, which includes valuable proprietary technology protected under several U.S. patents. It sells the premium fixtures for the same transfer price ($10 per fixture) as the regular fixtures and earns the same profit margin ($4 per fixture) on these sales. • In 2006, Globalco sold 200,000 premium fixtures and reported $800,000 of net income from these transactions. On audit, the IRS determines that the price per premium fixture should have been $41, increasing Globalco’s net income by $6.2 million.
  10. 10. Example: Transfer Pricing for Globalco • Penalty? Which one? Yes. Gross valuation misstatement. The assessed arm’s length transfer price is greater than arm s 400% of Globalco’s intercompany transfer price. Number of Premium fixtures: , 200,000 Assessed Arm’s Length Price: $41 Less: USCO’s COGS $6 Adjusted Net Income: 200,000 * $35 $7,000,000 Less: Reported Net Income - $800,000 Amount of Underpayment: $6,200,000 $6 200 000 Amount of Tax Underpayment (ETR=35%): 35% * $6,200,000 $2,170,000 Penalty (Gross): 40% * $2,170,000 + $868,000 Tax Underpayment + Penalty: $3,038,000
  11. 11. Reasonable Cause and Good Faith • If a company can show that there was reasonable cause for the underpayment and that it acted in good faith, then IRC § §6664(c) provides that no penalty under §6662 will be imposed. ( ) y § By demonstrating that an allocation is excluded from calculations of the net §482 penalty, a taxpayer will be treated as having established reasonable cause and good faith with respect to that allocation, and a transactional penalty will not be imposed. However, if contemporaneous documentation is not provided within 30 days of IRS’ request evidencing the basis for the taxpayer’s transfer price reflected in the return under examination, then the taxpayer may not satisfy the reasonable cause and good f i h exception i f h bl d d faith i requirements.
  12. 12. Net Adjustment Penalty • With respect to transfer pricing, the net adjustment penalty is based on the sum of all increases and decreases in taxable income that results from a series of transactions in which the transfer price is determined by the IRS to not be arm’s length. • Substantial vs. Gross valuation misstatement Substantial misstatement– Net adjustment is greater than misstatement the lesser of $5 million dollars or 10 percent of gross receipts. Penalty – 20 percent of the underpayment of taxes. e a ty 0 pe ce t o t e u de pay e t o ta es Gross misstatement – Net adjustment is greater than the lesser of $20 million dollars or 20 percent of gross receipts. Penalty – 40 percent of the underpayment of taxes taxes.
  13. 13. Exclusion from Net Adjustment Penalty • An amount is excluded from the calculation of a net §482 adjustment if the taxpayer establishes that both the method – whether specified or unspecified – and the documentation requirements are met with respect to that amount. Specified methods refer to those methods described in §482. A qualified cost sharing arrangement is also considered a specified method. This requirement is met if the taxpayer selected and applied a specified method in a reasonable manner. Whether the taxpayer’s conclusion was reasonable must be determined from all the facts and circumstances. circumstances To meet the unspecified method requirement, the taxpayer must demonstrate that it made a reasonable effort to evaluate the applicability of the specified methods and concluded that none of the specified methods would clearly reflect income and that the unspecified method would clearly reflect income.
  14. 14. Exclusion from Net Adjustment Penalty • The documentation requirement is met if the taxpayer maintains documentation to establish that it used the method that provided the most accurate measure of an arm’s length g result, given available data. This documentation must be in existence when the return is filed and must be provided to the IRS within 30 days of request. The documentation includes principal and background documents. A list of the ten principle documents is provided in the Appendix.
  15. 15. Example: Transfer Pricing for Globalco • Considering the same base facts in the foregoing examples, Globalco sold 1.8 million fixtures and reported $7.2 million of net income. The IRS determines that the transfer price per fixture should have been $13, increasing Globalco’s net income by $5.4 million. • In this example, even though the adjustment does not meet the threshold of the transactional penalty (assessed arm’s length price is $13, which is not greater than 200 percent of the intercompany price of $10), the increase in net income is greater than $5 million and it is subject to the net adjustment penalty at the substantial valuation misstatement level.
  16. 16. Example: Transfer Pricing for Globalco • Globalco sold 8 million fixtures and reported $32 million of net income. The IRS determines that the transfer price per fixture should have been $13. Its allocation and adjustment increases Globalco’s net income by $24 million. • Even though this adjustment does not meet the threshold of the transactional penalty, it is greater than $20 million, and thus subject to the net adjustment penalty at the gross valuation misstatement level.
  17. 17. Setoff Allocation Rule • In cases in which the taxpayer may meet some but not all of the exclusions to the net adjustment penalty under §482 adjustments, setoffs must be applied ratably against all such j y g allocations. Example. The IRS makes two §482 adjustments. Adjustment 1: $9 million / Excluded from penalty Adjustment 2: $6 million / Not excluded from penalty Setoff under §1.482-1(g)(4): $5 million The setoff must be allocated proportionally which means proportionally, [$9 mm / ($9 mm + $6 mm) x $5 mm] + [$6 mm / ($9 mm + $6 mm) x $5 mm] = $3 million (A1) + $2 million (A2) = $5 million
  18. 18. Coordinating the Penalties • Under this penalty regime, it is entirely possible that a taxpayer could be assessed a transactional penalty but no net adjustment penalty at one end of the spectrum, or could be assessed a net adjustment penalty but no transaction penalty. • Only one penalty, at the highest applicable rate, will be applied. The same underpayment in taxes will not be penalized twice.
  19. 19. Key Considerations for U.S. Multinationals • Two Penalties Transactional penalties and/or net adjustment penalties may apply. Have you quantified the full extent of your Company’s potential exposure? ? • Intercompany Services Because of the associated costs, adjustments to transfer prices for intercompany services can q p y quickly meet the transactional p y penalty level. y Has your Company historically and/or is it now changing arm’s length prices for intercompany services? • Contemporaneous Documentation Contemporaneous d C t documentation i th only way t potentially avoid t ti is the l to t ti ll id penalties if the IRS adjusts transfer prices. Are you prepared to respond to an IRS request for transfer pricing documentation within 30 days?
  20. 20. Appendix: 10 Principle Documents Overview of the taxpayer’s business, including an analysis of the economic and legal factors that 1. affect the pricing of its property or services; Description of the organizational structure of all related parties engaged in transactions potentially 2. relevant under section 482; Documentation explicitly required by the regulations under section 482, which may include 3. unspecified transfer pricing methods, profit split methods, and/or cost sharing agreements; 4. Description of the method selected and an explanation of why it was selected; Description of alternative methods that were considered and an explanation of why they were not 5. selected; Description of the controlled transactions (including the terms of sale) and any internal data used p ( g ) y 6. 6 to analyze those transactions; Description of the comparables that were used, how comparability was evaluated, and what (if 7. any) adjustments were made; 8. 8 Explanation of the economic analysis and projections relied upon in developing the method; Description of any relevant data that the taxpayer obtains after the end of the tax year and before 9. filing a tax return, which would help determine if a taxpayer selected and applied a specified method in a reasonable manner; and A general i d of th principal and b k l index f the i i l d background d d documents and a d t d description of th record- i ti f the d 10. keeping system used for cataloging and accessing those documents.
  21. 21. Contact us Verse Consulting LLC 1200 Smith Street, Suite 1600 Houston, Texas 77002 713-353-3964 (main) 713 353 4601 713-353-4601 (fax) info [at] verseconsulting [dot] com
  22. 22. The Fine Print • Not to be repurposed or sold. • This presentation is provided for information purposes only and is not intended to constitute tax advice which may be relied upon to avoid penalties under any federal, state, local or other tax statutes or regulations, and do not resolve any tax issues in your favor. Upon request, we can provide you with express written tax advice after necessary factual development and subject to such conditions and qualifications as we may deem appropriate under the circumstances. i t

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