US Transfer Pricing Regime

This resource provides background information on the United States transfer pricing regime.

The US law is under Internal Revenue Code section 482, a two sentence paragraph. The first sentence of Internal Revenue Code (IRC) §482 dates back to 1928 and authorizes the Secretary of the Treasury to allocate certain tax items among commonly controlled entities in order to prevent the evasion of tax or to clearly reflect the income of any such entities. The second sentence was added as part of the Tax Reform Act of 1986 and is known as the commensurate-with-income requirement. That is, that with respect to transfer or license of intangible property, the income with respect to such intangible property shall be commensurate with the income attributable to the intangible. See below for the IRC §482:

In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.

In addition, section 6662 of the IRC defines the transfer pricing documentation requirements and the respective penalties for non-compliance. This §6662, titled Imposition of accuracy-related penalty on underpayments, can be found at the Legal Information Institute website.

In contrast to the two sentence IRC §482, its supporting regulations page count is in the hundreds. The US regulations contain a very high level of specificity on the relevant economic theory, analysis methods to employ. The regulations provide numerous examples on how to apply the arm’s length standard. The regulations can also be found at the Legal Information Institute website.

The accompanying regulations of IRC §6662 can be found at the Legal Information Institute website. The first part of these regulations provide examples and details regarding the non-compliance penalties. The ten principal documents that is required to be prepared to avoid these penalties are described in more detail in the regulations at §1.6662-6(d)(2)(iii)(B).

In June of 2016, final regulation §1.6038-4 were released that require annual country-by-country reporting by certain United States persons that are the ultimate parent entity of a multinational enterprise group that has annual revenue for the preceding annual accounting period of $US 850,000 or more. These regulations (in pdf form) can be found at the United States Government Publishing Office.

The IRS has also made various International Practice Units (IPUs) related to transfer pricing publically available. These IPUs have been prepared, in a slide deck format, to provide guidance to IRS examiners that are auditing transfer pricing issues. These IPUs provide insight on how the IRS will examine your related party transactions. There are at least 29 IPUs related to transfer pricing that address a range of specific issues such as

• Management Fees,
• the Arm’s Length Standard,
• the Best Method Determination,
• Duplicative Services,
• Interest rates,
• license, sale and transfer of intangibles, and
• cost sharing versus licensing alternative structures.

The full listing of these IPUs, including transfer pricing related IPUs, can be found at the IRS website .

Included in the US federal income tax return is the Form 5471 and 5472. Form 5471 is titled Information Return of U.S. Persons With Respect to Certain Foreign Corporations and Form 5472 is titled Information Return of a 25% Foreign Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. An audit team for a taxpayer will include an international auditor when either one of these forms are included in the tax return. The IRS website has both Form 5471 and Form 5472 on its website.

Form 8975 collects information related to country-by-country reporting requirements. The information required is described within regulations §1.6038-4.

The final Section 6662 regulations stipulate that penalties can be asserted when IRS adjustments to taxpayers’ returns are warranted, and that these penalties can be avoided through contemporaneous documentation of a reasonable cause and good faith effort to establish appropriate transfer pricing policies. The regulations define two types of penalties, the substantial valuation misstatement and the gross valuation misstatement.

A substantial valuation misstatement occurs when the IRS makes a transfer pricing adjustment and:

1. the original transfer price is 200 percent or more or 50 percent or less of the determined price; or
2. the net Section 482 adjustment is greater than the lesser of $5 million or 10 percent of gross receipts. A substantial valuation misstatement results in a penalty of 20 percent of the underpayment of tax attributable to the misstatement.

A gross valuation misstatement will result in a 40 percent penalty. A gross valuation misstatement occurs when the IRS makes an adjustment and:

1. the original transfer price is 400 percent or more or 25 percent or less of the determined price; or
2. the net Section 482 adjustment is greater than the lesser of $20 million or 20 percent of gross receipts.

These misstatement penalties can be avoided if taxpayers demonstrate that they acted reasonably and in good faith in their intercompany transactions. Specifically, the reasonable cause and good faith standard requires “fact and circumstance” analysis in which the taxpayer demonstrates an effort to accurately determine tax liability. A taxpayer can also establish reasonable cause and good faith by meeting the documentation requirements relating to net Section 482 adjustments.

The following is a list of documents specified under Section 1.6662-6(d)(2)(iii)(A-C). At the time the tax return is filed, taxpayers must have in existence the principal documents #1 through #8 and background documents, and must provide this documentation to IRS within 30 days of a request for it.

1. Overview of taxpayer’s business, including the economic and legal factors affecting pricing;
2. Description of the taxpayer’s organizational structure, including all related entities with transactions which are potentially covered under Section 482;
3. Copies of any documents required under Section 482, such as agreements or pricing arrangements;
4. Description of the method selected and an explanation of why that method was selected;
5. Description of the alternative methods that were considered and an explanation of why they were not selected;
6. Description of the controlled transactions and any internal data used to analyze the controlled transactions;
7. Description of the comparable companies that were used, how comparability was evaluated, and any adjustments that were made;
8. Explanation of the economic analysis relied upon in developing the method;
9. Description or summary of relevant data obtained after end of tax year and before filing the tax return; and
10. General index of the principal and background documents and a description of the record keeping system used for cataloging and accessing those documents.

Background documents support the principal documentation. These documents may be necessary to establish that the taxpayer’s method was selected and applied in the way that provided the most accurate measure of an arm’s-length result. Background documents may include: historical data of the comparables, Forms 10-K, budgets, invoices, interview notes, third-party agreements, strategic plans, manuals, specifications, or other descriptions of functions performed.