Summary discussion of the U.S. accuracy-related tax penalties. Important information for companies with transfer pricing considerations.

1. U.S. Transfer Pricing Accuracy-
Related Tax Penalties
Internal Revenue Code §6662
Verse Consulting LLC
October 2009

2. Contents
• Introduction
• The Penalties
Transactional Penalty
Examples
Reasonable Cause and Good Faith Exception
Net Adjustment Penalty
Examples
Exclusion from Net Adjustment Penalty
Setoff Allocation Rule
• Coordinating the Penalties
• Key Considerations for U.S. Multinationals
• Appendix: 10 P i i l D
A di Principle Documents
t

3. Introduction
• The U.S. Internal Revenue Code (IRC)
p
provides for nearly 150 p
y penalty
y
provisions.
• With respect to transfer pricing the
most important penalties to understand
are those under IRC §6662
§6662.

4. Transactional Penalty
• With respect to transfer pricing, the transactional penalty
applies to individual transactions in which the transfer price is
determined not to be arm’s length by the IRS.
g y
• Substantial vs. Gross Valuation Misstatement
Substantial misstatement – Transfer price for a specific
transaction is 200 percent or more (or 50 percent or less) of
the correct price determined under §482.
Penalty – 20 percent of the tax underpayment.
Gross misstatement – Transfer price for a specific
transaction is 400 percent or more (or 25 percent or less) of
the correct price determined under section §482.
Penalty – 40 percent of the tax underpayment
underpayment.

5. Example: Transfer Pricing for Globalco
• Globalco manufactures regular light fixtures at its U.S. plant and
transfers them to its subsidiaries worldwide for distribution.
Globalco reported income based upon a transfer price of $10
for each fixture.
Globalco’s cost of goods sold (COGS) is $6 and it earns $4
gross profit per fixture.

6. Example: Transfer Pricing for Globalco
• In 2006, Globalco had a record year and sold 10 million regular
fixtures and reported $40 million of net income. On audit, the
IRS determined that the transfer price per fixture should have
been $13, increasing Globalco’s net income by $3 million.
• Penalty? Which one?
No penalty.
Globalco would not be subject to the transactional
penalty since the arm’s length transfer price assessed is
arm s
not greater than 200 percent (50 percent or less) of the
intercompany transfer price.

7. Example: Transfer Pricing for Globalco
• 2008 was a terrible year for Globalco. The company sold
250,000 regular fixtures and reported $1,000,000 of net income.
On audit, the IRS determines that the price per fixture should
have been $30.
• Penalty? Which one?
Yes. Substantial valuation misstatement.
Globalco would face the 20 percent transactional penalty
because the arm’s length transfer price assessed is
arm s
greater than 200 percent of the amount Globalco claimed
on its return.

8. Example: Transfer Pricing for Globalco
Penalty calculation
Number of fixtures sold 25,000
Assessed Arm’s Length Price: $30
Less: Globalco’s COGS $6
Adjusted Net Income: 25,000 * $24 $600,000
Less: Reported Net Income ($100,000)
Amount of Underpayment: $500,000
$500 000
Amount of Tax Underpayment (ETR=35%): 35% * $500,000 $175,000
Penalty (Substantial): 20% * $175,000 $35,000
Tax Underpayment + Penalty: $210,000

9. Example: Transfer Pricing for Globalco
• Globalco also manufactures premium light fixtures at its U.S.
plant, which includes valuable proprietary technology protected
under several U.S. patents. It sells the premium fixtures for the
same transfer price ($10 per fixture) as the regular fixtures and
earns the same profit margin ($4 per fixture) on these sales.
• In 2006, Globalco sold 200,000 premium fixtures and reported
$800,000 of net income from these transactions. On audit, the
IRS determines that the price per premium fixture should have
been $41, increasing Globalco’s net income by $6.2 million.

10. Example: Transfer Pricing for Globalco
• Penalty? Which one?
Yes. Gross valuation misstatement.
The assessed arm’s length transfer price is greater than
arm s
400% of Globalco’s intercompany transfer price.
Number of Premium fixtures: ,
200,000
Assessed Arm’s Length Price: $41
Less: USCO’s COGS $6
Adjusted Net Income: 200,000 * $35 $7,000,000
Less: Reported Net Income - $800,000
Amount of Underpayment: $6,200,000
$6 200 000
Amount of Tax Underpayment (ETR=35%): 35% * $6,200,000 $2,170,000
Penalty (Gross): 40% * $2,170,000 + $868,000
Tax Underpayment + Penalty: $3,038,000

11. Reasonable Cause and Good Faith
• If a company can show that there was reasonable cause for the
underpayment and that it acted in good faith, then IRC
§
§6664(c) provides that no penalty under §6662 will be imposed.
( ) y §
By demonstrating that an allocation is excluded from
calculations of the net §482 penalty, a taxpayer will be
treated as having established reasonable cause and good
faith with respect to that allocation, and a transactional
penalty will not be imposed.
However, if contemporaneous documentation is not
provided within 30 days of IRS’ request evidencing the
basis for the taxpayer’s transfer price reflected in the
return under examination, then the taxpayer may not
satisfy the reasonable cause and good f i h exception
i f h bl d d faith i
requirements.

12. Net Adjustment Penalty
• With respect to transfer pricing, the net adjustment penalty is
based on the sum of all increases and decreases in taxable
income that results from a series of transactions in which the
transfer price is determined by the IRS to not be arm’s length.
• Substantial vs. Gross valuation misstatement
Substantial misstatement– Net adjustment is greater than
misstatement
the lesser of $5 million dollars or 10 percent of gross
receipts.
Penalty – 20 percent of the underpayment of taxes.
e a ty 0 pe ce t o t e u de pay e t o ta es
Gross misstatement – Net adjustment is greater than the
lesser of $20 million dollars or 20 percent of gross receipts.
Penalty – 40 percent of the underpayment of taxes
taxes.

13. Exclusion from Net Adjustment Penalty
• An amount is excluded from the calculation of a net §482 adjustment if
the taxpayer establishes that both the method – whether specified or
unspecified – and the documentation requirements are met with
respect to that amount.
Specified methods refer to those methods described in §482. A
qualified cost sharing arrangement is also considered a specified
method. This requirement is met if the taxpayer selected and
applied a specified method in a reasonable manner. Whether the
taxpayer’s conclusion was reasonable must be determined from all
the facts and circumstances.
circumstances
To meet the unspecified method requirement, the taxpayer must
demonstrate that it made a reasonable effort to evaluate the
applicability of the specified methods and concluded that none of
the specified methods would clearly reflect income and that the
unspecified method would clearly reflect income.

14. Exclusion from Net Adjustment Penalty
• The documentation requirement is met if the taxpayer
maintains documentation to establish that it used the method
that provided the most accurate measure of an arm’s length g
result, given available data.
This documentation must be in existence when the return is
filed and must be provided to the IRS within 30 days of
request. The documentation includes principal and
background documents.
A list of the ten principle documents is provided in the
Appendix.

15. Example: Transfer Pricing for Globalco
• Considering the same base facts in the foregoing examples,
Globalco sold 1.8 million fixtures and reported $7.2 million of net
income. The IRS determines that the transfer price per fixture
should have been $13, increasing Globalco’s net income by
$5.4 million.
• In this example, even though the adjustment does not meet the
threshold of the transactional penalty (assessed arm’s length
price is $13, which is not greater than 200 percent of the
intercompany price of $10), the increase in net income is greater
than $5 million and it is subject to the net adjustment penalty at
the substantial valuation misstatement level.

16. Example: Transfer Pricing for Globalco
• Globalco sold 8 million fixtures and reported $32 million of net
income. The IRS determines that the transfer price per fixture
should have been $13. Its allocation and adjustment increases
Globalco’s net income by $24 million.
• Even though this adjustment does not meet the threshold of the
transactional penalty, it is greater than $20 million, and thus
subject to the net adjustment penalty at the gross valuation
misstatement level.

17. Setoff Allocation Rule
• In cases in which the taxpayer may meet some but not all of the
exclusions to the net adjustment penalty under §482
adjustments, setoffs must be applied ratably against all such
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allocations.
Example. The IRS makes two §482 adjustments.
Adjustment 1: $9 million / Excluded from penalty
Adjustment 2: $6 million / Not excluded from penalty
Setoff under §1.482-1(g)(4): $5 million
The setoff must be allocated proportionally which means
proportionally,
[$9 mm / ($9 mm + $6 mm) x $5 mm] + [$6 mm / ($9 mm
+ $6 mm) x $5 mm] = $3 million (A1) + $2 million (A2) =
$5 million

18. Coordinating the Penalties
• Under this penalty regime, it is entirely possible that a taxpayer
could be assessed a transactional penalty but no net adjustment
penalty at one end of the spectrum, or could be assessed a net
adjustment penalty but no transaction penalty.
• Only one penalty, at the highest applicable rate, will be applied.
The same underpayment in taxes will not be penalized twice.

19. Key Considerations for U.S.
Multinationals
• Two Penalties
Transactional penalties and/or net adjustment penalties may apply.
Have you quantified the full extent of your Company’s potential
exposure? ?
• Intercompany Services
Because of the associated costs, adjustments to transfer prices for
intercompany services can q
p y quickly meet the transactional p
y penalty level.
y
Has your Company historically and/or is it now changing arm’s length
prices for intercompany services?
• Contemporaneous Documentation
Contemporaneous d
C t documentation i th only way t potentially avoid
t ti is the l to t ti ll id
penalties if the IRS adjusts transfer prices.
Are you prepared to respond to an IRS request for transfer pricing
documentation within 30 days?

20. Appendix: 10 Principle Documents
Overview of the taxpayer’s business, including an analysis of the economic and legal factors that
1.
affect the pricing of its property or services;
Description of the organizational structure of all related parties engaged in transactions potentially
2.
relevant under section 482;
Documentation explicitly required by the regulations under section 482, which may include
3.
unspecified transfer pricing methods, profit split methods, and/or cost sharing agreements;
4. Description of the method selected and an explanation of why it was selected;
Description of alternative methods that were considered and an explanation of why they were not
5.
selected;
Description of the controlled transactions (including the terms of sale) and any internal data used
p ( g ) y
6.
6
to analyze those transactions;
Description of the comparables that were used, how comparability was evaluated, and what (if
7.
any) adjustments were made;
8.
8 Explanation of the economic analysis and projections relied upon in developing the method;
Description of any relevant data that the taxpayer obtains after the end of the tax year and before
9. filing a tax return, which would help determine if a taxpayer selected and applied a specified
method in a reasonable manner; and
A general i d of th principal and b k
l index f the i i l d background d d documents and a d
t d description of th record-
i ti f the d
10.
keeping system used for cataloging and accessing those documents.

21. Contact us
Verse Consulting LLC
1200 Smith Street, Suite 1600
Houston, Texas 77002
713-353-3964 (main)
713 353 4601
713-353-4601 (fax)
info [at] verseconsulting [dot] com

22. The Fine Print
• Not to be repurposed or sold.
• This presentation is provided for information purposes only and
is not intended to constitute tax advice which may be relied
upon to avoid penalties under any federal, state, local or other
tax statutes or regulations, and do not resolve any tax issues in
your favor.
Upon request, we can provide you with express written tax advice
after necessary factual development and subject to such conditions
and qualifications as we may deem appropriate under the
circumstances.
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