Increased U.S. transfer-pricing enforcement: What’s at stake?

Editor: Greg A. Fairbanks, J.D., LL.M.

Over the last four years, the IRS has reversed its performance in transfer-pricing litigation during the previous four decades and achieved unprecedented success in transfer-pricing cases dealing with well-known taxpayers and extremely large amounts of taxes, penalties, and interest. Further encouraging better transfer-pricing documentation compliance, the IRS has repeatedly announced its intention to assert transfer-pricing penalties more aggressively, even when the taxpayer has documentation, if that documentation is deemed insufficient. The increased transfer-pricing exposure is not limited to tax compliance; financial reporting for transfer-pricing issues could also be affected by these two enforcement changes.

In this new enforcement environment, taxpayers should reevaluate their U.S. transfer-pricing compliance. First, taxpayers should reevaluate their risk assessments for noncompliance due to potential costs based on recent IRS wins and assertion of penalties. Next, taxpayers should update their existing documentation for issues such as best method selection and whether the functional analysis is robust enough to satisfy the IRS’s reasonable-application standard. Finally, taxpayers should consider whether a proactive approach, such as the Advance Pricing Agreement (APA) Program or International Compliance Assurance Program (ICAP), could reduce overall global transfer-pricing exposure.

History of IRS transfer pricing enforcement

The IRS management has maintained a decades-long commitment to enforcing transfer-pricing rules. However, the Service’s poor track record in transfer-pricing litigation has historically weakened its position with taxpayers in examination.

Examinations and litigation: Since 2012, the IRS has taken meaningful steps to strengthen its transfer-pricing exam and litigation record. The Service created the Transfer Pricing Practice (TPP), a group of national transfer-pricing specialists that develop and coordinate transfer-pricing strategy, training, and operational approaches to key transfer-pricing issues (Stewart, “IRS Official Elaborates on Plans for Transfer Pricing Pilot Program,” 58 Tax Notes International, 310 (April 26, 2010)). Establishment of the TPP helped to improve transfer-pricing litigation outcomes, since case selection and early development occur at examination. Further, the IRS began to designate cases for litigation, a move seldom used since the 1990s. Finally, the IRS has more actively coordinated case choice and development between TPP and its Office of Chief Counsel.

Penalties: The Sec. 6662 valuation penalty for transfer pricing imposes 20% and 40% nondeductible penalties for transfer-pricing valuation misstatements for which adjustments produce an increase in U.S. income tax (Secs. 6662(a), (e)(1)(B)(ii), (e)(3), and (h)(1)). Adjustments are excluded from the net Sec. 482 adjustment calculation to the extent the taxpayer can demonstrate that it determined its price using a transfer-pricing method in a reasonable manner (Sec. 6662(e)(3)(B)(i)). Note that these methods are referred to as “specified methods” in the regulations for this section, e.g., Regs. Sec. 1.6662-6(d)(2). Historically, the transfer-pricing penalty has been difficult for the IRS to impose, and penalties have not been proposed in all cases where the thresholds were met.

Financial reporting for uncertain tax positions

In 2006, FASB addressed how companies identify, measure, and report uncertain tax positions (UTPs) on their GAAP financial statements, first with FASB Interpretation No. (FIN) 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109, Accounting for Income Taxes, and later with Accounting Standards Codification (ASC) Topic 740 (Income Taxes). For this purpose, transfer pricing is considered a tax “position.”

Topic 740 requires that tax positions be evaluated using a two-step process. The first step is recognition or nonrecognition of a tax position: “An enterprise shall initially recognize the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination” (FASB ASC ¶740-10-25-6). The second step is measured as the largest amount of tax benefit “that is greater than 50 percent likely of being realized upon settlement with a taxing authority that has full knowledge of all relevant information” (FASB ASC ¶740-10-30-7). The difference between the amount reported on the tax return and the measured amount is often referred to as the “tax reserve” or “tax provision.”

Current IRS transfer pricing enforcement

In recent years, the IRS has experienced dramatic improvement in transfer-pricing case outcomes, achieving at least a partial win in four major transfer-pricing cases in a three-year period.

Examinations and litigation: The IRS won Altera Corporation, 926 F.3d 1061 (9th Cir. 2019), regarding cost-sharing regulations that require the inclusion of stock-based compensation in cost-sharing cost pools. The U.S. Supreme Court declined to review the Ninth Circuit’s decision.

On Nov. 18, 2020, the Tax Court issued its decision in Coca-Cola Company, 155 T.C. 145 (2020), rejecting the taxpayer’s reliance on a 1996 settlement agreement and reallocating income from Puerto Rico manufacturing affiliates to the U.S. taxpayer based on a comparable-profits method (CPM) analysis. The opinion upheld the IRS’s reallocation of approximately $9 billion of income to the United States for tax years 2007—2009, but the amount was reduced by $1.8 million because the taxpayer satisfied the royalty obligation with dividends paid by Puerto Rico manufacturing subsidiaries.

In 2023, the Tax Court held for the IRS in a “blocked income” case, 3M Company, 160 T.C. No. 3 (2023). This outcome produced a $27.8 million adjustment.

The Tax Court in 2022 redecided Medtronic, Inc., T.C. Memo. 2022-84, on remand from the Eighth Circuit (Medtronic, Inc., 900 F.3d 610 (8th Cir. 2018)). The Tax Court rejected the IRS’s CPM arguments, finding that the CPM did not compensate Medtronic PR for its quality control function and product liability risk. The court ultimately applied a three-step unspecified method to determine the appropriate royalties, resulting in approximately $1.4 billion in adjustments for 2005 through 2006.

The IRS’s examination approach is affecting taxpayers in a big way: In October 2023, Microsoft disclosed in its SEC Form 8-K, Current Report, filing that the Service is seeking additional payment of $28.9 billion, plus penalties and interest.

Penalties: Over the last few years, multiple IRS executives have publicly stated that the Service is looking to assert more transfer-pricing penalties in appropriate cases. The IRS’s intention is twofold: (1) If triggering amounts are met, it will consider the assertion of penalties under Sec. 6662, and (2) adjustments will be excepted from the penalty calculations only if the taxpayer reasonably applied the transfer-pricing analysis. The recent Microsoft examination discussed above is among several in which the IRS has asserted penalties against taxpayers.

Financial reporting for uncertain tax positions

In recent years, certain taxpayers that disclosed the existence of transfer-pricing disputes in their SEC Form 10-K, Annual Report, pursuant to ASC 740 reporting requirements have risked shareholder lawsuits for lack of full disclosure on the amount of taxes, penalties, and interest at issue.

ASC 740 reporting requires a two-step analysis to determine the reportability of UTPs, such as transfer-pricing determinations. Many taxpayers have addressed the application of ASC 740 in a manner that entails an expectation that penalties will not be imposed due to the existence of documentation and that the company will pursue litigation as far as necessary to secure an expected favorable outcome. This approach produces no or low tax reserves, which in the eyes of shareholders may be too little information about the taxpayer’s internal risk analysis of material tax exposures.

Current issues for improved transfer pricing compliance

In light of the significant improvement in IRS transfer-pricing enforcement outcomes and its express intention to impose more penalties, taxpayers are encouraged to upgrade their transfer-pricing compliance and update their documentation for any creeping changes to functions, risks, and intangibles.

The IRS’s 2020 FAQs on transfer-pricing documentation elaborate on areas where transfer-pricing documentation may be deficient and ways to improve. First, rather than rejecting a comparable uncontrolled price (CUP) method for lack of data, the IRS expects the taxpayer to describe why such comparable transactions do not exist (Q&A 4). Second, the IRS expects a full description of general business risks of the intercompany transaction and how these risks are allocated among the controlled participants (Q&A 5).

Finally, the IRS expects to see how profits are allocated among the related parties, the origin of any excess returns, and which controlled party is entitled to these returns, based on how and where value is created (Q&As 4 and 5). The IRS notes that value creation is both relative to an industry in which a company operates and company-specific, depending on a company’s unique facts.

Practitioners with industry experience should assist a taxpayer with describing its unique value creation process and industry circumstances (e.g., COVID-19-based operational challenges and changes) in the taxpayer’s transfer-pricing documentation to mitigate risk of IRS challenge to selection of the best transfer-pricing method and independent comparables used, among other factors.

In addition to enforcement, the IRS is committed to working with taxpayers to prevent costly, protracted disputes. Taxpayers that want to proactively manage their transfer-pricing exposure can use the information developed through the reevaluation to determine whether an APA or an ICAP could reduce their global transfer-pricing risk.

An APA is a voluntary process whereby a multinational enterprise (MNE) files a request that sets out relevant facts, background materials, and economic analyses for the proposed covered transactions. Following the request, the tax authorities issue information requests to supplement the submitted materials, followed by meetings and negotiations with the MNE. The process can be long and labor-intensive, often lasting between 1½ to two years in the case of a unilateral APA, with an additional two years required for bilateral or multilateral negotiations between the IRS and foreign tax administrations. The process can be expensive; the user fee for an original APA is currently $113,500, with adviser fees to prepare the submission, respond to information requests, and attend meetings.

At the end of the process, the MNE and the involved governments execute a binding agreement setting out the covered transactions, transfer-pricing method, agreement duration, and other relevant terms. As long as the MNE adheres to the terms, the covered transactions will not be adjusted. An APA eliminates the need to prepare documentation studies on the covered transactions; reduces customs exposure; and, in the case of a bilateral APA, eliminates the possibility of double tax on the covered transactions.

ICAP is a voluntary process that differs from an APA in several respects. An ICAP submission is generally limited to information an MNE should already possess, such as transfer-pricing studies and country-by-country reporting data. The process is expected to take 24 to 28 weeks following submission of the requested information, but the timeframe varies depending on the complexity of the transactions and number of countries involved.

ICAP can cover several transactions and countries; most APAs cover only two countries. ICAP requires no user fee, while APAs require substantial filing fees. APAs can cover several years prospectively and can be rolled back to filed years; ICAP generally covers only two filed years and, under certain conditions, can be rolled forward an additional two years. ICAP can provide an MNE with “assurance” that participating tax administrations do not anticipate further review of the covered risks for a defined period; an APA provides enforceable certainty.

Penalties more likely

Changes made by the IRS in the selection, development, and litigation strategy of transfer-pricing issues have improved IRS outcomes in transfer-pricing litigation. The improved litigation outcomes strengthen the IRS’s position in transfer-pricing examinations. Further, the IRS expects to increase its assertion of penalties in transfer-pricing cases, even where the taxpayer has documentation. The combination of these changes encourages taxpayers to upgrade and update their global transfer-pricing compliance efforts and use any information developed through that process to determine whether a proactive approach such as an APA or ICAP could reduce their global transfer-pricing exposure.

Editor Notes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C. For additional information about these items, contact Fairbanks at greg.fairbanks@us.gt.com. Contributors are members of or associated with Grant Thornton LLP.