Transfer pricing penalties may apply under IRC Section 6662 when the IRS finds that a company used a transfer price that was significantly different from the arm’s-length price. In simple terms, if the difference is large enough, the company may have to pay a penalty in addition to the additional tax.
Next, let’s understand the different types of transfer pricing penalties in the United States.
When the IRS finds that a company’s transfer prices are not appropriate, it may make an adjustment under IRC Section 482. In some cases, this adjustment can also result in a penalty under IRC Section 6662(e).
There are two main types of transfer pricing penalties, which are as follows:
1. Transactional penalty
The transactional penalty focuses on a specific related-party transaction. It may apply when the price reported by the company is significantly different from the arm’s-length price determined by the IRS.
For example, suppose a U.S. company buys products from its foreign parent for $1 million. The IRS determines that an unrelated company would have paid $2 million for the same products under similar circumstances. If the difference is large enough to meet the legal threshold, a transactional penalty may apply.
2. Net adjustment penalty
Net adjustment penalty looks at the combined effect of all Section 482 adjustments made for the year rather than looking at just one transaction.
For example, suppose the IRS finds that the prices used in several transactions between a U.S. company and its foreign parent were not arm’s length. The IRS makes several adjustments that together increase the company’s taxable income. If the total adjustment is large enough to meet the applicable threshold, a net adjustment penalty may apply.
In simple terms, the transactional penalty looks at one transaction, while the net adjustment penalty looks at the total Section 482 adjustments for the year.
Depending on the size of the transfer pricing misstatement, the penalty is generally 20% or 40% of the resulting tax underpayment. Next, let’s understand how this transfer pricing penalty rate is determined.
The transfer pricing penalty rate depends on the severity of the transfer pricing error. Under IRC Section 6662, a taxpayer may face a 20% or 40% penalty when a transfer pricing adjustment meets the applicable requirements.
Generally, the larger the difference between the price reported by the taxpayer and the amount determined to be correct, the higher the potential penalty.
First, let’s understand the 20% transfer pricing penalty.
When a U.S. company does business with a related company, the IRS expects the price to be similar to what unrelated companies would have agreed to. This is known as the arm’s-length price.
If the price reported by the company is significantly different from the arm’s-length price, a 20% transfer pricing penalty may apply.
The 20% transfer pricing penalty applies in the following ways:
1. Looking at One Transaction
The first approach examines a specific transaction and compares the company’s reported price with the correct arm’s-length price.
A 20% penalty may apply if the reported price is:
For example, let’s say the correct arm’s-length price is $1 million. Then the reported price of $2 million or more, or $500,000 or less, may meet the threshold for the penalty. This is because these reported prices are either 200% or 50% of the correct arm’s length price of $1 million.
2. Looking at All Transactions Together
The second approach looks at the total adjustment made by the IRS for all related-party transactions during the year.
A 20% penalty may apply when the total adjustment is more than the lower of:
For example, if a company has gross receipts of $30 million. So, the 10% would be $3 million. Since $3 million is less than $5 million, the threshold would be $3 million.
If the IRS makes several transfer pricing adjustments that total more than $3 million, the company may meet the threshold for the 20% penalty.
Next, let’s understand how the 20% penalty is calculated.
The 20% penalty is not calculated on the transfer pricing adjustment itself. Instead, it is generally calculated based on the additional tax the company owes due to the adjustment.
For example, if the transfer pricing adjustment results in the company owing an additional $100,000 in tax, a 20% penalty would be $20,000.
$100,000 additional tax × 20% = $20,000 penalty
So, the key point is that the 20% penalty applies to the additional tax owed, not to the transfer pricing adjustment amount.
Now that we have understood the 20% transfer pricing penalty, next let’s understand the 40% transfer pricing penalty.
A 40% transfer pricing penalty may apply when the difference between the company’s reported price and the correct arm’s-length price is especially large.
The 40% transfer pricing penalty applies in the following ways:
1. Looking at One Transaction
The first approach looks at one specific transaction and compares the reported price with the correct arm’s-length price.
A 40% penalty may apply if the reported price is:
For example, suppose the correct arm’s-length price is $1 million. If the company reports a price of $4 million or more, or $250,000 or less, the transaction may meet the threshold for the 40% penalty. This is because the reported price is either 400% or more or 25% or less of the correct arm’s length price of $1 million.
2. Looking at All Transactions Together
The second approach looks at the total Section 482 adjustments made by the IRS for all related-party transactions during the year.
A 40% penalty may apply when the total adjustment is more than the lower of:
For example, suppose a company has $50 million in gross receipts during the year. Twenty percent of its gross receipts is $10 million. As $10 million is lower than $20 million, the applicable threshold is $10 million.
If the IRS makes several transfer pricing adjustments that total more than $10 million, the company may meet the threshold for the 40% penalty.
Next, let’s understand how the 40% penalty is calculated.
A transfer pricing adjustment does not automatically result in a 40% penalty. The adjustment should meet the applicable requirements and thresholds for the penalty to apply.
The 40% penalty is generally calculated on the additional tax owed due to the transfer pricing adjustment, not on the adjustment itself.
For example, suppose the IRS determines that a company’s transfer pricing adjustment increases its taxable income by $5 million. Further, assuming the company’s resulting additional tax is $1.5 million.
The $5 million adjustment does not automatically mean that a 40% penalty applies. The adjustment should first meet the applicable requirements and thresholds for the 40% penalty.
If the penalty does apply, it would generally be calculated on the additional tax of $1.5 million, not on the $5 million transfer pricing adjustment.
$1.5 million additional tax × 40% = $600,000 penalty
So, the company would generally face a $600,000 penalty, rather than a $2 million penalty based on 40% of the $5 million adjustment.
Now that we have discussed the different types of transfer pricing penalties in the United States. Next, let’s understand whether a company can avoid a transfer pricing penalty in the United States.