Transfer pricing penalty pitfalls.

• Author: Gibson, Thomas

Temporary regulations under Sec. 6662 (as updated by the Revenue Reconciliation Act of 1993) have been issued by the IRS to replace the 1993 proposed regulations and provide guidance for the accuracy-related penalties relating to the Sec. 482 intercompany pricing rules. These penalties have the power to hit unsuspecting taxpayers (small start-up operations and billion dollar multinationals alike) with penalties of up to 40% of the underpayment of tax as determined by the Service.

A 20% penalty is imposed on "substantial" transfer pricing valuation misstatements, which occur if the price claimed on an income tax return for any property or service transferred between related parties is 200% or more (or 50% or less) of the amount determined to be the correct price under Sec. 482 (the "transactional penalty"). The 20% penalty is also triggered if a Sec. 482 adjustment for the tax year exceeds the lesser of $5 million or 10% of the taxpayer's gross receipts (the "net adjustment penalty"). The penalty imposed is doubled to 40% for "gross" transfer pricing valuation misstatements that occur if the price claimed on an income tax return for any property or service transferred between related parties is 400% or more (or 25% or less) of the amount determined to be the correct price under Sec. 482, or if the net Sec. 482 adjustment exceeds the lesser of $20 million or 20% of the taxpayer's gross receipts. Taxpayers must consider that the 40% penalty will apply in the following common scenarios.

Example: A U.S. parent (P) owns 100% of a foreign manufacturing and distributing subsidiary (F).

* Scenario 1: F uses P's name in the course of marketing its product, without compensating P with royalty payments. The IRS determines F should be paying P a royalty of $200,000 for the value of P's name. The 40% penalty is applicable even though the adjustment is small; adjusting from zero to any number exceeds the gross valuation misstatement threshold.

* Scenario 2: P purchases replacement or spare parts for its specialized manufacturing equipment and holds them for future needs. To better service foreign customers, P transfers a portion of them to F at cost, totaling $50,000. Under Sec. 482, the Service determines the fair market value of these specialized parts is $200,000 and adjusts P's taxable income to reflect $150,000 gain on the sale.

* Scenario 3: P's marketing department has developed a program that has proven to be very effective in marketing its...