Comments on transfer pricing penalty under Section 6662(e).

On February 28, 1991, the Internal Revenue Service issued proposed regulations under sections 6662 and 6664 of the Internal Revenue Code, concerning the accuracy-related penalty for substantial understatements of income tax, for negligence or disregard of rules and regulations, and for substantial valuation misstatements. The proposed regulations (IA-015-90) were published in the Federal Register on March 4, 1991 (56 Fed. Reg. 8959), and in the April 1, 1991, issue of the Internal Revenue Bulletin (1991-13 I.R.B. 24). (1) A public hearing was held on June 3, 1991. TEI submitted written documents on May 13, 1991, and testified at the public hearing. Regulations concerning transactions between persons described in section 482 and net section 482 transfer price adjustments were reserved under Prop. Reg. [subsection] 1.6662-5(j) and 1.6664-4(d) and are the subject of a separate regulation project (IA-035-91). In connection with that project TEI is pleased to submit these comments to supplement its original submission on section 6664(c)'s reasonable-cause and good-faith exception (hereinafter, "reasonable-cause exception") to imposition of the accuracy-related penalties.

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our nearly 4,700 members represent approximately 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

TEI members are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under sections 6662 and 6664 of the Code and, in particular, the application of the reasonable-cause exception to the imposition of penalties for valuation misstatements in connection with net section 482 adjustments.

General Principles

The Internal Revenue Code imposes a penalty of 20 percent of the amount of any understatement of tax attributable, among other things, to "substantial valuation misstatements" as defined in section 6662(e). (2) As part of the Omnibus Budget Reconciliation Act of 1990, Congress extended the substantial valuation misstatement penalty to understatements of tax attributable to "net section 482 transfer price adjustments" that exceed certain thresholds. The penalty under new section 6662(e) will be imposed either (1) when transfer price adjustments in any one taxable year exceed $10 million dollars, or (2) when the transfer price or adjusted basis for property or services exceeds 200 percent or more (or is 50 percent or less) of the amount ultimately determined to be the "correct" transfer price. Under section 6662(h), the amount of the penalty is increased to 40 percent of the understatement of tax if there is a "gross valuation misstatement." A gross valuation misstatement is determined by substituting "$20 million" for "$10 million," "400 percent" for "200 percent," and "25 percent" for "50 percent."

Under section 6664(c) of the Code, the section 6662 penalty does not apply to any portion of an understatement (including understatements attributable to net section 482 adjustments) if the taxpayer had reasonable cause for the position taken and acted in good faith with respect to that position. Furthermore, under section 6662(e)(3)(B)(i), in determining whether the $10 million or $20 million thresholds are exceeded, a section 482 adjustment will be disregarded to the extent that the taxpayer can demonstrate reasonable cause and good faith in setting the transfer price.

The determination of "correct" transfer prices between related parties is an inherently factual undertaking. IRS examinations of intercompany pricing have resulted in intense and protracted litigation battles with taxpayers. Recent court cases under section 482 contain factual summaries and opinions that compete with 19th century Russian novels--or, perhaps, Satanic Verses -- in length (and, some might argue, lack of perspicuity.) Regardless of one's view of the outcome of transfer price cases, the court cases invariably demonstrate that highly trained, renowned economists can disagree substantially on the appropriate pricing method in a particular factual setting. That is to say, there is never a single, unassailable "right" answer. In an area such as transfer pricing, where "20/20 hindsight" is often applied by IRS examiners, TEI believes that the reasonable-cause exception should be interpreted to mitigate the severe underpayment penalty that may result from second-guessing a taxpayer's analysis and interpretation of complex factual data. In other words, we believe the section 6662(e) penalty should apply only in limited circumstances to instances of demonstrable culpability. (3) Such an approach would be consistent with the thrust of penalty reform.

In revamping the Internal Revenue Code's penalty regime in 1989, Congress recognized that penalties were being unevenly and unfairly assessed under old section 6661. (4) Penalties are intended to encourage compliant behavior and to punish taxpayer misconduct. Penalties can have a salutary effect on deterring proscribed behavior, however, only where the proper (or improper) course of conduct is known in advance. As Prop. Reg. [section] 1.6664-4(b) itself acknowledges, the most important factor to be considered in applying the reasonable-cause exception is the extent of the taxpayer's effort to self-assess his proper tax liability. Because the...