Best Practices to Avoid Transfer Pricing Penalties in the United States

Companies may be able to avoid potential transfer pricing penalties in the U.S. by following the best practices outlined below.

Timely Preparation of Transfer Pricing Documentation

One of the most important ways to reduce transfer pricing penalty risk is to prepare proper documentation before or by the time the tax return is filed. A company should not wait until the IRS initiates an audit to create documentation supporting its transfer pricing position.

However, simply having a transfer pricing report is not enough to automatically protect a company from penalties. The IRS may review whether the documentation actually supports the company’s transfer pricing position.

For example, the IRS may consider the following factors:

• Whether the company used an appropriate transfer pricing method;
• Whether the company relied on reliable information and data;
• Whether it considered the relevant facts and circumstances;
• Whether the analysis properly supports the prices reported on the tax return; and
• Whether the calculations in the documentation are consistent with the company’s actual financial results.

If the documentation is incomplete, unreliable, or does not properly support the company’s pricing, the company may not qualify for penalty protection.

Next, let’s understand what the transfer pricing documentation should include to avoid penalties.

What Should the Transfer Pricing Documentation Include?

U.S. transfer pricing rules require specific information to support a taxpayer’s transfer pricing position. The documentation should generally explain the following:

• The company’s business and organizational structure;
• The related companies involved;
• The related-party transactions;
• The functions performed by each company;
• The assets used and risks assumed by each company;
• The transfer pricing method selected;
• Why the method was appropriate;
• The economic analysis and comparable information used;
• How the method was applied;
• How the transfer pricing results were calculated; and
• How the analysis relates to the company’s actual financial results.

In other words, the documentation should clearly explain what the company did, why it chose its pricing method, what information it used, and how it arrived at its transfer price.

For U.S. companies operating in multiple countries, OECD-style master files and local files may also be maintained as part of their global transfer pricing compliance. However, these documents should not be confused with the specific U.S. documentation requirements.

The United States does not simply require every taxpayer to prepare an OECD-style master file and local file. Instead, taxpayers should focus on meeting the U.S. documentation requirements under IRC Section 6662 and Treasury Regulation §1.6662-6.

A company’s master file or local file may contain useful supporting information, but it should be reviewed to make sure it also addresses the specific U.S. requirements.

Therefore, good transfer pricing documentation should be prepared on time, based on reliable information, and clearly explain why the company’s pricing is reasonable. A report that merely exists in the company’s files may not provide penalty protection if it does not actually support the company’s position.

Next, let’s understand another best practice for avoiding transfer pricing penalties: reasonable cause and good faith.

Reasonable Cause and Good Faith

A company may also avoid a penalty by demonstrating reasonable cause and good faith. This generally means the company made a genuine effort to determine the correct tax treatment and acted reasonably based on the information available to it.

For example, the company may have relied on qualified tax professionals and followed their advice in determining its transfer prices.

However, a company cannot avoid a transfer pricing penalty simply by saying that it tried to get the pricing right. It should be able to show its work.

Using a reasonable pricing method, preparing proper documentation on time, and explaining the analysis to the IRS can help reduce the risk of transfer pricing penalties.

Now that we have understood how companies may be able to avoid transfer pricing penalties, let’s next understand other types of penalties that may arise from transfer pricing adjustments in the United States.