January 12, 2018
Control No: LB&I-04-0118-003
MEMORANDUM FOR LARGE BUSINESS AND INTERNATIONAL DIVISION EMPLOYEES
|From:||Douglas W. O’Donnell
Commissioner, Large Business and International Division
|Subject:||Instructions for Examiners on Transfer Pricing Issue Examination Scope - Appropriate Application of IRC §6662(e) Penalties|
This Directive provides instructions to Large Business & International (LB&I) examiners with respect to the assertion of penalties in certain transfer pricing examinations.
Transfer pricing issues make up a substantial portion of the LB&I inventory. As a result, significant LB&I resources are devoted to transfer pricing issues. LB&I recognizes that it needs to manage transfer pricing issues under examination and related resources in the most efficient and effective manner possible. This Directive provides instructions with respect to managing certain transfer pricing issues in inventory.
This Directive only applies to examinations of LB&I taxpayers (i.e., assets equal to or greater than $10,000,000) who are required to file (including extensions) forms 5471 or 5472 with their original annual US tax return.
TRANSFER PRICING EXAMINATION GUIDANCE: IRC §6662(e) penalties should be applied if appropriate
Regulations require the IRS to apply penalties when the taxpayer fails to create or to timely provide IRC §6662(e) documentation or when the IRC §6662(e) documentation provided is unreasonable or inadequate, assuming the net adjustment penalty thresholds are met.
In May 1993, the House Report (103-111 (for H.R. 2264)) for the Omnibus Budget Reconciliation Act of 1993 (P.L. 103-66) (Title XIII-Revenue Reconciliation Act of 1993) that strengthened the penalty rules stated: “The committee does not believe that a section 482 adjustment that exceeds the threshold generally should escape the penalty unless the taxpayer can show that the return position was arrived at after bestowing a reasonable amount of attention to the issue.” Thus, the penalty rules serve the dual purpose of holding taxpayers accountable for the reasonableness of their return positions and helping to motivate taxpayers and their advisors to not only take reasonable return positions but also to adequately document them. Unless a taxpayer’s IRC §6662(e) documentation is adequate and timely, the regulations require the net adjustment penalty to be assessed in every case where the penalty thresholds are met.
Failure to apply penalties when appropriate has adverse consequences. First, we may not be properly using a legislative tool intended to encourage taxpayer compliance. Second, there is less incentive for taxpayers to initially provide adequate and timely documentation. Inadequate, incomplete or untimely production of documentation at the start of the examination makes it much more difficult and resource intensive for the examination team to assess a taxpayer’s reporting position and adds to audit time, which is also an increased taxpayer burden. Appropriate application of penalties when documentation is inadequate maintains accountably and encourages reasonable and well-documented return positions that may be assessed more efficiently, saving resources for both the IRS and taxpayers.
Having IRC §6662(e) documentation does not automatically protect against penalties. The IRC §6662(e) documentation must also be assessed for adequacy and reasonableness. To meet the reasonable cause exception of the penalty regulations, taxpayers must document they reasonably selected the best method for their analysis and they reasonably applied that best method. Factors to consider in evaluating the adequacy of a taxpayer’s transfer pricing documentation are outlined in the regulations. For example, a taxpayer cannot rely on an unreasonable selection or application of a specified method to avoid penalties (e.g., inaccurate inputs, failure to adequately search for or consider material information, failure to follow best method rule in selecting and applying the method, results that differ significantly from the arm’s length result and that are sizable in relation to the controlled transaction, etc., are indications the IRC §6662(e) documentation may be inadequate).
When the taxpayer has timely provided an analysis and conclusion selecting a specified method as the best method, examiners should use such method as the starting point for their examination of the reasonableness of the selection and application of the method. (See Directive LB&I-04-0118-002 for further guidance with respect to consideration of the taxpayer’s best method selection). The transfer pricing regulations do not impose a hierarchy or preference of methods for given transactions but some methods make more sense in certain situations. The examples in Treas. Reg. §1.482-8 are instructive in considering how to evaluate the reasonableness of the taxpayer’s best method analysis. If the examiner determines the taxpayer’s best method selection is not reasonable and receives approval to apply an alternative method as the best method, subject to the best method guidance referenced above, penalties would apply if the resulting adjustments are in excess of the threshold amount. Further, if the documentation does not explicitly include an analysis and conclusion that the method used is the best method, penalties would apply if adjustments to tax exceed the penalty regulation threshold.
Whether the threshold is met for the net adjustment penalty is determined on an aggregate basis (the sum of all increases in the taxable income of the taxpayer for the taxable year under IRC §482, netted against decreases for collateral adjustments), with the total reduced by adjustments for which the taxpayer had adequate contemporaneous documentation. For example, the gross valuation misstatement penalty is applicable if five adjustments of $4M each are upheld and there is inadequate documentation, even though none of the adjustments is by itself enough to meet either of the thresholds. Even if the IRS position is not fully sustained, the final resolution may result in a tax adjustment that is higher than the penalty thresholds.
IRC §6662(e) documentation is defined so that it is limited solely to documentation that was both prepared prior to filing of the return and provided to the IRS within 30 days of request. If the IRC §6662(e) documentation is inadequate on its own, a taxpayer generally may not protect against penalties by supplementing with documents that were prepared after the date of filing of the return or that were not provided to the IRS within the 30-day deadline.
Notwithstanding that IRC §6662(e) penalty protection is limited to the information and analysis in the IRC §6662(e) documentation, the IRS can and should consider whether there are other sources of relevant data. For example, the examination team should be probing what data and information the taxpayer had access to or should reasonably have identified and considered at the time of the transaction. Knowing what information was or should have been available to the taxpayer assists the examination team in determining if the taxpayer adequately searched for, considered and applied the relevant body of information and whether the taxpayer adequately incorporated and addressed that data in its IRC §6662(e) documentation analysis.
The evaluation of the applicability of penalties should be undertaken after the examination team has completed enough of its analysis to know the order of magnitude of the potential adjustment and has a deep factual background on the issue(s). It is important not to forget to complete the often long and complex transfer pricing analysis with a diligent penalty analysis. As with all other penalties, the manager’s written approval is required before assertion of the penalty (ideally when the penalty is initially raised and, if not completed earlier, before the issuance of a 30-day letter or notice of deficiency). Documentation of that approval must be maintained in the case file.
For convenient reference, below are links to the Internal Revenue Manual (IRM) section that outlines our procedures in this area.
IRM https://www.irs.gov/irm/part20 See specifically IRM 18.104.22.168.3-Managerial Approval of Penalties.
For further information regarding this Directive and any of the specific issues addressed herein, please contact the Director of Treaties and Transfer Pricing Operations.
This Directive is not an official pronouncement of law and cannot be used, cited or relied upon as such. In addition, nothing in this Directive should be construed as affecting the operation of any other provision of the Code, regulations or guidance thereunder.
cc: Division Counsel, LB&I