The historical shift in transfer pricing penalty enforcement

Editor: Mary Van Leuven, J.D., LL.M.

The IRS’s enforcement of transfer pricing penalties has undergone a marked transformation in recent years. Historically, the assertion and sustenance of penalties in transfer pricing cases were rare, with the IRS focusing primarily on the underlying adjustments to income under Sec. 482. This approach made sense: The main effect of the penalty regime was to incentivize taxpayers to properly consider and document their intercompany pricing decisions contemporaneously with filing their federal income tax returns, thus reducing information asymmetry at the start of the audit. However, there has been a pronounced shift in recent years, with penalties now routinely asserted by IRS exam teams in many cases — even where taxpayers have maintained contemporaneous transfer pricing documentation. This item analyzes developments in transfer pricing penalty enforcement and examines the implications of this shift for taxpayers.

Penalties and documentation

Sec. 482 permits the IRS to adjust intragroup transfer prices if necessary to clearly reflect the transacting parties’ income. Historically, one major challenge for the IRS when asserting Sec. 482 adjustments was that U.S. taxpayers either did not document their transfer pricing policies or did so only in memoranda that were privileged and hence unavailable, making examinations difficult and burdensome. In the early 1990s, Congress enacted Sec. 6662(e)(3) — which imposes a penalty equal to 20% of a Sec. 482 underpayment — to encourage taxpayers to devote a reasonable amount of time and attention to documenting their intercompany transactions. Sec. 6662(h) increases this penalty to 40% if certain thresholds are met. As the legislative history makes clear, Congress intended these penalties to apply to taxpayers that disregarded transfer pricing altogether — those that paid “no apparent consideration as to whether the taxable income reported, and the tax paid, conforms with the standards made applicable by section 482” and “little or no regard whether it could be justified under section 482 standards” (H.R. Rep’t No. 103–111, 103rd Cong., 1st Sess., p. 720 (1993)). As such, only one defense to the transfer pricing penalty was provided: contemporaneous documentation of the transfer pricing methodology. To obtain penalty protection, a taxpayer must:

• Establish that the transfer price was determined in accordance with a specified transfer pricing method under the Sec. 482 Treasury regulations and that the method was applied in a reasonable manner;
• Prepare documentation contemporaneously with filing the tax return, supporting the reasonable selection and application of the transfer pricing method; and
• Provide this documentation to the IRS within 30 days of a request (Sec. 6662(e)(3)(B); Regs. Sec. 1.6662-6(d)).

More general defenses such as reasonable cause and good faith do not apply to the transfer pricing penalty; to obtain protection, documentation of a reasonable methodology is necessary. As such, companies with material cross–border intercompany transactions now typically prepare robust annual transfer pricing reports. This in itself addresses Congress’s main concern — a lack of effort and attention from taxpayers.

Historical experience

In the authors’ experience, prior to around the late 2010s, IRS exam teams almost uniformly refrained from asserting transfer pricing penalties in cases where the taxpayer had contemporaneous documentation. This experience is borne out by a review of litigated cases arising from adjustments made prior to 2015 — a period characterized by a number of landmark transfer pricing cases with significant amounts at stake but a relative dearth of penalties. Again, that dearth makes sense: The mere fact that the IRS and the taxpayer disagree on transfer pricing, even if the Service ultimately prevails, is no reason to assert penalties. Notably, the penalty regime has facilitated the IRS’s ability to bring these large transfer pricing cases by encouraging taxpayers to prepare and provide the Service with detailed documentation.

On occasion, the IRS did assert penalties on adjustments that found their way to litigation. In Veritas Software Corp., 133 T.C. 297 (2009), the IRS asserted 40% transfer pricing penalties but withdrew the penalties prior to trial.Similarly, in Guidant LLC, 146 T.C. 60 (2016), the IRS asserted a transfer pricing penalty even though the taxpayer had prepared transfer pricing documentation but conceded the penalty issue. In Xilinx Inc., 125 T.C. 37 (2005), aff’d, 598 F.3d 1191 (9th Cir. 2010), the IRS asserted the penalty for disregard of regulations, which is related to but distinct from the normal transfer pricing penalty, but lost on the underlying issues in the Tax Court (and ultimately in the Ninth Circuit as well). As the Tax Court explained, “Because we reject respondent’s determinations, petitioners are not liable for section 6662(a) penalties.”

The IRS took a particularly aggressive stance on penalties in Eaton Corp., 47 F.4th 434 (6th Cir. 2022). Although the case was not resolved until 2022, the petition dates to 2012 and involves the IRS’s attempted cancellation of the taxpayer’s advance pricing agreements (APAs) due to computational errors, despite the taxpayer’s having proactively and promptly corrected those errors with amended returns. The IRS sought to replace the APA methodology with a completely different method and imposed penalties as well. The Sixth Circuit concluded that the IRS wrongfully canceled the APAs. Before trial, the IRS had asserted penalties only in connection with the adjustments based on its substitute methodology; after trial, it sought to apply penalties to the taxpayer’s self–initiated adjustments. The Sixth Circuit held that the IRS had forfeited its claim to penalties on the taxpayer’s self–initiated adjustments because it had not raised the claim at or before trial.

Throughout this period, the IRS prevailed on penalties in only a single transfer pricing case: Wycoff, T.C. Memo. 2017–203, which involved a closely held business and stands apart from the normal run of transfer pricing cases involving large multinationals. The taxpayer was found to have avoided taxes through management fees for which no substantiation was produced. The Tax Court emphasized that “[n]either did petitioners introduce any documentary evidence with respect to how the management fees were determined. Petitioners claim a document existed, but they claimed they did not have it.” Further, the court found that the taxpayer failed to seek the advice of advisers with economic experience. In this context — where the taxpayer failed to produce any substantiation for its transfer pricing — the IRS’s assertion of penalties was sustained, and the taxpayer was held liable for over $1 million in penalties. Interestingly, in Wycoff the IRS did not assert the normal transfer pricing penalty but the related penalties for negligence or disregard of rules or regulations and for substantial understatement of income tax.

The shift: Penalty assertion becomes routine

The landscape of transfer pricing penalty enforcement shifted dramatically after the late 2010s. In 2018, the IRS issued a directive requiring that penalties be evaluated in all circumstances where the (relatively low) thresholds are met. Further, the IRS’s internal procedures now require transfer pricing exam teams to justify why they would not assert penalties. In contrast to the prior decade, the IRS now routinely asserts penalties in many transfer pricing cases, even where taxpayers have maintained contemporaneous documentation prepared by qualified advisers. The IRS’s focus is no longer whether documentation is maintained but whether that documentation is sufficient. In some cases, the authors’ experience has been that exam teams are quick to dismiss documentation that does not align with their own position, particularly as to the selection and application of the transfer pricing method. Such exam teams misconstrue the analysis required by Secs. 482 and 6662(e)(3), improperly conflating into one analysis the separate questions of (1) whether an adjustment should apply and (2) whether penalties should apply.

This shift is borne out by a review of currently docketed transfer pricing cases. The enforcement shift in the late 2010s becomes clear in transfer pricing cases docketed after 2020, at which point penalties begin appearing in the majority of notable transfer pricing cases across industries. Indeed, most if not all of the other docketed cases for which penalties are now on the table also involve taxpayers that maintained transfer pricing documentation, setting up the IRS for a series of battles not just on the underlying transfer pricing issues but potentially on the sufficiency of documentation as well.

Until recently, no court had analyzed the sufficiency of documentation as a defense to the transfer pricing penalty. This changed in 2025 when the District Court for the Western District of Michigan issued its opinion in Perrigo Co., No. 1:17–cv–00737 (W.D. Mich. 9/25/25). Although the IRS’s primary position in Perrigo related to economic substance, it also asserted an alternative transfer pricing theory, including penalties. Although — as is common in transfer pricing litigation — the taxpayer’s litigating position employed a different methodology than its contemporaneous documentation, the court held that because the taxpayer reasonably relied on a qualified adviser to prepare documentation, the transfer pricing penalty did not apply. In doing so, the court swept aside the government’s argument that the original analysis was unreasonable because it undercompensated the U.S. taxpayer: “That argument, standing alone, carries little weight because this whole inquiry will only arise if there has been some type of failure to adequately compensate.” The holding in Perrigo aligns with Congress’s intent for the penalty regime, as reflected in the legislative history discussed above, and the court’s reasoning offers an important reminder to the IRS that penalties do not apply simply because the taxpayer and the Service differ in their views of the underlying substantive issue. Time will tell if this causes the IRS to moderate its recent approach to transfer pricing penalties.

More important than ever

Until recently, penalty assertions in even the largest transfer pricing cases were rare. The current enforcement environment is fundamentally different. At first blush, this may seem to make documentation irrelevant: If IRS exam teams are asserting penalties regardless, why bother? That perspective fails to consider the ultimate disposition of these cases. Given the recent ruling in Perrigo, it is clear the courts still attach significant weight to the existence of documentation from a qualified adviser. With IRS exam teams increasingly disposed to assert penalties, the quality of documentation is actually more important than ever: If it does not convince an exam team, the documentation will need to convince IRS Appeals or a court that the taxpayer’s position was reasonable, and taxpayers should approach their documentation with that goal in mind.

Editor

Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.

For additional information about these items, contact Van Leuven at mvanleuven@kpmg.com.

Contributors are members of or associated with KPMG LLP.

The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230. The information contained in these articles is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. These articles represent the views of the authors only and do not necessarily represent the views or professional advice of KPMG LLP.