Proposed section 482 penalty regulations.

On April 21, 1992, Tax Executives Institute submitted the following comments to the Internal Revenue Service on its proposed regulations under sections 6662(e) and 6662(h) of the Internal Revenue Code, relating to the imposition of the accuracy-related penalty for substantial and gross valuation misstatements attributable to section 482 allocations. The comments were prepared under the aegis of the Institute's International Tax Committee, whose chair is Lisa Norton of IngersollRand Company. The following TEl members also contributed materially to the submission: Robert Lamm of the Aluminum Company of America, Richard L. Satro of the Boeing Company, Katen A. Radtke of General Motors Corporation, and Raymond G. Rossi of Intel Corporation. Ms. Norton testified on TEI's behalf at a May 14 public hearing on the proposed regulations.

On January 13, 1993, the Internal Revenue Service issued proposed regulations under sections 6662(e) and 6662(h) of the Internal Revenue Code, relating to the imposition of the accuracy-related penalty for substantial and gross valuation misstatements attributable to section 482 allocations. The regulations were published in the Federal Register on January 21, 1993 (58 Fed. Reg. 5304), and in the Internal Revenue Bulletin on February 16, 1993 (1993-7 I.R.B. 78).

Contemporaneously with the issuance of the proposed section 6662 regulations, the IRS issued temporary and proposed regulations under section 482 of the Code, relating to intercompany transfer pricing.(1) For simplicity's sake, the proposed section 6662 regulations are referred to as the "proposed penalty regulations" or "proposed regulations" and the proposed and temporary section 482 regulations are referred to as the "substantive section 482 regulations" or the "temporary regulations." Specific provisions are cited as "Prop. Reg. (section). or "Temp. Reg.(Section)." References to page numbers are to the proposed penalty regulations (and preamble) as published in the Internal Revenue Bulletin.

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our nearly 4,800 members represent 2,300 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.

Members of TEI 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 section 6662(e) of the Code, relating to the imposition of the accuracy-related penalty for substantial and gross valuation misstatements attributable to section 482 allocations.

Overview

Section 6662(e) of the Internal Revenue Code imposes a penalty of 20 percent of the amount of any understatement of tax attributable to "substantial valuation misstatements." The penalty is to be imposed either (i) when the transfer price adjustments in any one taxable year exceed $10 million, or (ii) when the transfer price or adjusted basis of the property or service 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), this socalled section 482 penalty is increased to 40 percent of the understatement if there is a "gross" valuation misstatement, which is defined as adjustments exceeding $20 million, or 400 percent or more (or 25 percent or less) of the "correct" transfer price. Under sections 6662(e)(3)(B)(i) and 6664(c)(1), the penalty does not apply to any portion of the understatement if there was a reasonable cause for the taxpayer's position and the taxpayer acted in good faith with respect to such position.(2)

In the preamble to the proposed penalty regulations, the IRS states that "[t]he experience of Internal Revenue Service examiners has been that the majority of taxpayers are unable to provide an explanation of how their intercompany pricing was established." 1993-7 I.R.B. at 79. The IRS continues that the lack of "contemporaneous documentation" of how a controlled transaction result was determined increases the time spent and the expense incurred by both the taxpayer and the IRS in determining whether that result was arm's length; it also increases controversy between taxpayers and the IRS. The preamble states that the proposed regulations are designed to encourage taxpayers to document their transfer pricing transactions and to provide that documentation to the IRS upon request. 1993-7 I.R.B. at 79. The proposed regulations thus impose a documentation requirement as a cornerstone of section 482 enforcement. Under the regulations, "contemporaneous documentation" is key to determining whether the taxpayer had a reasonable cause for setting its transfer prices and acted in good faith with respect to such prices.

TEI does not quarrel with the concept that a taxpayer should be required to substantiate its transfer prices through documentation. Section 6001 of the Code states as much. We submit, however, that the proposed penalty regulations overemphasize documentation of the "right" method as an indispensable element of the reasonable cause exception. The proposed penalty regulations thus confuse a procedural requirement to substantiate a position taken on the return--through documentation of the prices and methodology used--with the substantive issue whether the taxpayer had a reasonable belief that its prices (however documented) were arm's length. By equating documentation with reasonable belief, the proposed penalty regulations place an undue compliance burden on taxpayers who may be required to document prices under multiple methods in order to avoid imposition of the penalty. Indeed, we believe legitimate questions exist about the IRS's authority to impose an explicit, time-sensitive requirement by administrative regulation.(3)

Penalties should be enacted to encourage compliant behavior and to punish taxpayer misconduct. To be effective in deterring culpable behavior, the penalty must warn taxpayers in advance that they will be held to a certain standard of conduct and the operative standard must be clearly defined and attainable. In reforming the Code's penalty regime in 1989, Congress recognized that penalties were being unevenly and unfairly assessed under old section 6661 (the substantial understatement penalty), among other provisions. H.R. Rep. No. 101247, 101st Cong., ist Sess. 1393 (1989) (hereinafter cited as the "1989 House Report"). Congress also confirmed that the mechanical assertion of penalties is simply wrong. See 1989 House Report at 1405 ("In the application of penalties, the IRS should make a correct substantive decision in the first instance rather than mechanically assert penalties with the idea they will be corrected later.").

TEI believes that the proposed penalty regulations should be revised to recognize that although section 482 adjustments may be made to ensure the clear reflection of income, such adjustments should give rise to a penalty only where there is demonstrably culpable behavior by the taxpayer. In other words, not every section 482 adjustment-even those above the section 6662(e) and (h) thresholds--should give rise to a penalty. Where the taxpayer acts reasonably to establish appropriate transfer prices, no penalties should be asserted. As the substantive section 482 regulations acknowledge, the determination of the "correct" transfer methodology between related parties is an inherently factual, complex undertaking and there is rarely any single, unassailable "right" answer.(4)

Moreover, although a mechanical test based on documentation of the correct method may seem relatively straight-forward and easy to administer, it threatens to produce the wrong result in too many cases. We believe congressional intent would be better served by a more subjective determination of whether the taxpayer had a reasonable cause for its actions. The objective prerequisite to avoiding the section 482 penalty, therefore, should be no more than a requirement that a taxpayer provide a "road map" or "audit trail" of its intercompany transactions, including information on the method used and any comparables relied upon. Once this threshold requirement is met, the taxpayer should be permitted to demonstrate, based on its specific facts and circumstances, that it acted reasonably and in good faith.(5)

Factors that may be relevant in determining whether a taxpayer satisfies the reasonable cause exception include the following: (i) whether the taxpayer obtained an economic study of its pricing; (ii) whether the taxpayer voluntarily disclosed the adjustment, perhaps by filing a qualified amended return; (iii) whether the adjustment is de minimis in relation to the taxpayer's overall pricing transactions; (iv) whether the taxpayer's transfer prices were consistent with prices established within a specific industry; (v) whether an unrelated party held a substantial minority interest in one of the parties to the transactions, especially where the taxpayer can substantiate arm'slength dealings between the parties; and (vi) whether there is an absence of a tax-avoidance motive (e.g., whether the taxpayer was operating in a hightax jurisdiction). In addition, taxpayers who obtain an advance pricing agreement or whose pricing methodology was sustained in or...