Intercompany transfer pricing penalties.

• Author: Bruno, Erasmo S.

In view of the Clinton administration's stated goal of raising substantial tax revenues, it is clear that a perceived source of revenue is international companies. Intensified audit activity of intercompany transactions with related foreign parties has already been experienced.

Even foreign-owned companies not targeted for audit have received "Third Party Information Requests" from the Service for exhaustive relevant intercompany pricing data. This information is used by the IRS in auditing other taxpayers.

Newly issued temporary and

proposed regulations

On Jan. 13, 1993, the Service issued temporary and proposed regulations relating to intercompany transfer pricing, which liberalized and added more flexibility to the previous rules. However, the quid pro quo for this relief is contemporaneous documentation.

More significantly, to encourage compliance with these new rules, the sanction of severe penalties has been reinforced.

The new regulations, together with the severe penalties for non-compliance, require corporate tax departments to become more involved with transfer pricing decisions and at an earlier stage. Further, the assistance of tax professionals is inevitable to cut through these intricate rules and to demonstrate that the taxpayer acted with reasonable cause and in good faith in setting transfer prices.

As a practical matter, the rules will force taxpayers to examine and document transfer pricing policies before they file their tax returns.

What is at stake?

Typically, IRS adjustments related to intercompany pricing merely shifted income between countries and did not affect the total worldwide tax burden. However, these new penalties, which are not deductible for U.S. income tax purposes, provide great incentive for companies to - review their intercompany pricing policies; - establish sound methods within the new rules for such pricing; and - contemporaneously document these policies and methods.

Otherwise, an unprepared company may find itself involved in a prolonged and costly IRS audit.

Accuracy-related penalty

A penalty may be imposed if a transfer price adjustment exceeds $10 million or if a transfer price claimed on a income tax return is 200% or more, or 50% or less, of the correct price.

The penalty is 20% of the tax underpayment attributable to the intercompany pricing adjustment. However, no penalty is imposed unless the tax underpayment exceeds the greater of 10% of the required tax or $10,000 for a regular...