Skip to content

Is the Transfer Pricing Penalty Counterproductive? A View Through the Commissioner’s Study

3 min readBy: J. Dwight Evans

Download Background Paper No. 10

Background Paper No. 10

Executive Summary The IRS Commissioner’s 1989 study of civil taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. penalties examined the philosophy, purpose, goals, and design of tax penalties and concluded that their sole objective is to encourage voluntary compliance with tax laws. The study found that there are three processes through which a tax penalty encourages voluntary compliance:

  • The setting and validation of standards of behavior, i .e., setting norms;
  • Deterring departures from the norms; and
  • Providing just deserts to taxpayers who depart from norms.

In measuring how well a penalty does the job of encouraging taxpayer compliance, the study asks:

  • Is the penalty fair?
  • Is the penalty effective?
  • Do taxpayers understand?
  • Can the IRS administer the penalty?

Specifically, the study concludes that the role of the accuracy penalty is to assure that taxpayers take reasonable care to file a reasonably accurate tax return.

At the same time that the IRS was conducting a comprehensive study of tax penalties it was also studying the problems which it encounters in enforcing the arm’s length inter-company transfer pricing standard of the Section 482 regulations. Beginning with the 1988 Intercompany Pricing White Paper and continuing through Congress’ deliberations in enacting OBRA’90 and93, the IRS has increasingly argued that the solution to the loss of revenue caused by alleged multinational taxpayer misevaluations in inter-company transfer pricing is the enactment of a new tax penalty designed to force the expedited production at auditA tax audit is when the Internal Revenue Service (IRS) conducts a formal investigation of financial information to verify an individual or corporation has accurately reported and paid their taxes. Selection can be at random, or due to unusual deductions or income reported on a tax return. of a taxpayer’s documents and records demonstrating arm’s length pricing standard. In OBRA’93 Congress enacted just such a penalty in the form of the transfer pricing “net adjustment penalty”.

The net adjustment penalty of 20%, or 40%in the case of gross valuation misstatements, requires taxpayers to contemporaneously document the correctness of their transfer prices when filing the tax return and produce that documentation within 30 days of an IRS request. The Section 482 net adjustment threshold is low; the lower of $5 million in adjustment or 10% of the taxpayer’s gross receipts. To avoid the penalty, the temporary regulations prescribe extensive rules for determining whether a taxpayer has used a reasonable method in determining its transfer prices, and require detailed documentation in support of that methodology.

The new transfer pricing net adjustment penalty involves a fundamental shift in focus from ensuring a reasonable level of correctness in a tax return to ensuring a very high level of taxpayer conduct in documenting the inter-company transfer prices used in the tax return and in cooperating with the IRS on audit of those prices.

Examining the provisions of the net adjustment penalty in light of the Commissioner’s study raises basic questions as to whether the net adjustment penalty is focused on correct norms of taxpayer conduct, will substantially enhance use of correct transfer prices, and will deter and punish the right parties. Also, based on criteria developed in the study to identify a “good penalty”, the issue is presented whether Congress and the IRS have created a tax penalty which in actual practice will prove to be very difficult to administer and counterproductive in reaching the stated objective of increased use by taxpayers of correct transfer prices in related party transactions.

Advanced pricing agreements, audit agreements, and an IRS penalty screening committee are proposals which may solve or help to mitigate the serious compliance and administrative problems in the transfer pricing penalty scheme.