Temporary and proposed transfer pricing penalty regulations.

• Position: Tax Executives Institute International Tax Committee

On June 2, 1994, Tax Executives Institute filed the following comments on proposed and temporary r sections 6662(e), 6662(h), and 6664(c) of the Internal Revenue Code, relating to the imposition of t for substantial and gross misstatements attributable to section 482 allocations. TEIS comments were aegis of its International Tax Committee, whose chair is Lisa Norton of the Ingersoll-Rand Company. materially to the preparation of the comments were Robert L. Ashby of Northern Telecom Inc., Stephen McDonald's Corporation, and Mark R. Gilmour of the Aluminum Company of America.

On January 27, 1994, the Internal Revenue Service issued temporary and re-proposed regulations under sections 6662(e), 6662(h), and 6664(c) 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. (At the same time, the IRS withdrew the proposed regulations that had been issued on January 21, 1993.) The new regulations were published in the Federal Register on January 27, 1994 (59 Fed. Reg. 4791, 4876), and in the Internal Revenue Bulletin on March 7, 1994 (1994-10 I.R.B. 6, 20).

For simplicity's sake, the most recent temporary and proposed regulations are referred to as the "temporary regulations" and the prior proposed regulations are referred to as the '1993 proposed regulations." Specific provisions are cited as "Temp. Reg. [sections]" or "Prop. Reg. [sections]." References to page numbers are to the temporary 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 approximately 5,000 members represent 3,000 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.

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 temporary regulations under sections 6662(e), 6662(h), and 6664(c) of the Code, relating to the imposition of the accuracy-related penalty for substantial and gross valuation misstatements attributable to section 482 allocations.

General Comments

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 so-called section 482 penalty is to be imposed either (i) when the transfer price adjustments in any one taxable year exceed the lesser of $5 million or 10 percent of the taxpayer's gross receipts,(1) 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.(2) Under section 6662(h), the 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 20 percent of the taxpayer's gross receipts), or 400 percent or more (or 25 percent or less) of the "correct" transfer price.

Last year, Congress adopted several changes to the net adjustment penalty. Section 13236 of the Omnibus Reconciliation Act of 1993 (OBRA) replaced the reasonable cause standard for avoiding the penalty under old law with a codification of the contemporaneous documentation requirements set forth in the 1993 proposed regulations.(3) Under the OBRA changes to section 6662(e)(3)(b), the penalty does not apply to any portion of the understatement if--

(i) the taxpayer determines its

transfer prices in accordance with a specific method set forth in the section 482 regulations (a "specified method"); (ii) the taxpayer has documentation

as of the time its return is filed that sets forth the determination of its prices in accordance with the specified method and that establishes the use of that method was reasonable; and (iii) the taxpayer provides such

documentation to the Secretary of the Treasury within 30 days of a request. A taxpayer not using a specified method may avoid the penalty if it satisfies the requirements in subsections (ii) and (iii) above and further establishes that (a) none of the specified methods was likely to have resulted in a price that clearly reflected income and (b) the non-specified method was likely to have resulted in such a price.(4)

In many respects, the temporary regulations represent a much-needed improvement over the 1993 proposed regulations. For example, the temporary regulations provide that a transfer pricing study from a prior year may be reasonably relied upon in a later year if the relevant facts or circumstances have not changed or if the study or analysis has been appropriately modified to reflect any change in facts and circumstances.(5) TEI recommended this practical approach in its comments on the 1993 proposed regulations and we commend the IRS for including the concept in the temporary regulations. We are also pleased with the clarification that the failure to make all the required adjustments under a specified...