Timing Is Crucial When Seeking Transfer Pricing Penalty Relief

The IRS has made good on its 2022 pledge to assert penalties more frequently in transfer pricing audits. Rarely does a transfer pricing dispute come out of IRS examination where it isn’t accompanied by a 20% or 40% penalty—or both.

Whatever the IRS’s policy rationale for proposing penalties as often as it now does—with Section 6662 documentation firmly in place or not—the effect has been to raise important questions for taxpayers on where they might seek redress.

This is particularly true today when, at the same time the IRS increased its transfer pricing audit and resulting penalty activity, taxpayers began utilizing more frequently competent authority consideration through the mutual agreement procedure under applicable income tax treaties.

So, with increased assertion of penalties coming at the same time as increased utilization of MAP, taxpayers are regularly evaluating their available routes of dispute resolution—not just for the IRS’s proposed transfer pricing adjustments but also for the penalties being asserted.

While litigation is always an option and a forum to address all issues, it is rarely, if ever, the best first option to resolve disputes. It is crucial then to examine the routes of alternative dispute resolution when a taxpayer is facing claims not only that its transfer pricing is inadequate but that its documentation, required under tax code Section 6662, is insufficient and subject to penalties by the IRS.

Competent authorities in a MAP case may play a role in resolving disputes, but the same goes for the IRS Independent Office of Appeals. Both are significant and important forums for resolving transfer pricing disputes, but each has its own procedural requirements—and limitations.

Taxpayers may protest both transfer pricing adjustments and penalties to the Appeals office after receiving a 30-day-notice letter. The Appeals office operates separately from the examination and collection teams, though its decision-makers are still IRS employees.

Similarly, when adjustments involve treaty countries, taxpayers may request assistance of the Advanced Pricing and Mutual Agreement program through a MAP filing for transfer pricing adjustments and transfer pricing penalties. This follows receipt of a proposed adjustment in writing, such as a Form 5701, Notice of Proposed Adjustment.

If accepted, the US competent authority (a Treasury Department appointee) will attempt to resolve these issues by consulting with the US treaty partner’s competent authority, though it may sometimes resolve these issues unilaterally.

Typically, the Appeals office and MAP are mutually exclusive. A taxpayer can’t seek resolution of the same issue in both forums simultaneously. APMA assumes exclusive jurisdiction over all issues submitted by the taxpayer once a request has been accepted.

Although taxpayers that can’t obtain satisfactory relief at MAP may protest to the Appeals office later, a taxpayer that first seeks resolution through the Appeals office may not later receive assistance from MAP. This underscores that the ordering and timing of seeking relief of various issues is essential.

The IRS’s frequent imposition of transfer pricing penalties has added a wrinkle to a taxpayer’s Appeals office-versus-MAP calculus. With MAP, APMA often will accept transfer pricing penalties as part of a competent authority request. In the past, APMA has dealt with transfer pricing penalties as part of competent authority cases.

But not all the US treaty partners are willing to accept transfer pricing penalties as part of their competent authorities’ negotiations. The majority of APMA’s top MAP treaty partners don’t, viewing penalties as purely a domestic issue.

In cases where the foreign competent authority isn’t inclined to weigh in on the IRS’s penalties, taxpayers that decide to challenge transfer pricing adjustments through MAP must either rely on APMA granting unilateral relief for any corresponding transfer pricing penalties (before or after reaching resolution with a treaty partner), or otherwise seek consideration of the penalties separately at the Appeals office.

If a taxpayer seeks a parallel-track approach, APMA would assume exclusive jurisdiction over the primary transfer pricing adjustment. Instead of requesting that APMA handle the transfer pricing penalties, the taxpayer would wait until the IRS examination team issues a 30-day letter that includes all issues that weren’t being considered under the MAP filing.

A taxpayer could then protest the transfer pricing penalties to the Appeals office, along with any other outstanding examination team issues, and seek resolution of the penalties outside the competent authority process.

Where does this leave taxpayers caught in a perfect storm of rising IRS transfer pricing adjustments, increasing imposition of penalties, and US treaty partners’ unwillingness to allow penalties into the MAP negotiations?

At least regarding penalties, taxpayers need to consider options such as parallel tracks at the Appeals office and through MAP. Although this may not appear to be the most efficient way to obtain relief, it may prove to be the only way—short of litigation—as overburdened APMA and Appeals office teams struggle to keep up with their ever-increasing caseloads.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Thomas V. Linguanti is partner at Morgan Lewis in Chicago focused on complex tax controversies and tax litigation.

Drew A. Cummings is an associate at Morgan Lewis in Washington, D.C. focused on federal income tax controversy matters.

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