December 1, 1994

Does the Transfer Pricing Penalty Violate the Fourth Amendment to the Constitution?

Download Background Paper No. 13

Background Paper No. 13

Executive Summary The U.S .Treasury has recently issued temporary regulations implementing a new regime of tax penalties relating to transfer prices. The redesigned penalties in Section 6662 (e) and (h) of the Internal Revenue Code (Code) are imposed on taxpayers who substantially understate taxable income as a result of misevaluation of the inter-company transfer prices used in their tax return. The new penalties are accompanied by temporary regulations relating in part to the supporting documents which taxpayers are required to have in hand when they file their tax returns and which, in order to avoid tax penalty, they must provide to the Internal Revenue Service (IRS) within 30 days of a “request” for such transfer pricing documentation.

Tax penalties are an important tool of tax administration. It has long been recognized, however, and the 1989 Report on Civil Tax Penalties for the Internal Revenue Service Commissioner (Commissioner’s Study) reaffirmed, that if a tax penalty is to be effective it must be perceived by taxpayers as being fairly and reasonably applied. The new Section 482 net adjustment penalties, particularly the rules requiring the creation and maintenance of supporting transfer pricing documents, and, specifically, the requirement that those documents be produced for IRS inspection at its request, raise questions whether these rules, as presently written, violate Fourth Amendment protections in the U .S .Constitution against unreasonable searches and seizures. Because the regulations have been issued in temporary form, it would be relatively easy for the IRS to address any Fourth Amendment difficulties before the regulations are issued in final form.