Transfer pricing documentation requirements in the United States of America

1. In your jurisdiction, are taxpayers obliged to maintain transfer pricing documentation? Does this obligation apply to all taxpayers, or only to certain categories (e.g. taxpayers with turnover or assets exceeding a particular threshold)?

In the United States, tax law governing transfer pricing is addressed under Internal Revenue Code Sections 482 and 6662, and associated regulations. Taxpayers with controlled transactions are required to maintain transfer pricing documentation, as covered in Section 6662, in order to avoid the imposition of penalties in the event of an adjustment to taxable income by the Internal Revenue Service. It is worth noting that a taxpayer is not automatically subject to penalty if contemporaneous transfer pricing documentation is not maintained. Transfer pricing related penalties can only be triggered by an adjustment to taxable income. This requirement applies to all US taxpayers, as the US rules and regulations do not provide a safe harbor for small taxpayers. Documentation requirements can be segmented into two categories: “Principal Documents” and “Background Documents”. Taxpayers and practitioners generally view an annual transfer pricing report documenting the arm’s length nature of intercompany transactions that cross US borders as comprising the Principal Documents.
These Principal Documents are:

  • An overview of the taxpayer’s business, including an analysis of the economic and legal factors that affect the pricing of its property or services;
  • A description of the taxpayer’s organizational structure (including an organization chart) covering all related parties engaged in transactions potentially relevant under Section 482, including foreign affiliates whose transactions directly or indirectly affect the pricing of property or services in the United States;
  • Any documentation explicitly required by the regulations under Section 482, such as for substantiation of a market share strategy or documentation required for cost sharing arrangements;
  • A description of the method selected and an explanation of why that method was selected;
  • A description of the alternative methods that were considered and an explanation of why they were not selected;
  • A description of the controlled transactions (including the terms of sale) and any internal data used to analyze those transactions. For example, if a profit split method is applied, the documentation must include a schedule providing the total income, costs, and assets (with adjustments for different accounting practices and currencies) for each controlled taxpayer participating in the relevant business activity and detailing the allocations of such items to that activity;
  • A description of the comparables that were used, how comparability was evaluated, and what (if any) adjustments were made;
  • An explanation of the economic analysis and projections relied upon in developing the method. For example, if a profit split method is applied, the taxpayer must provide an explanation of the analysis undertaken to determine how the profits would be split;
  • A description or summary of any relevant data that the taxpayer obtains after the end of the tax year and before filing a tax return, which would help determine if a taxpayer selected and applied a specified method in a reasonable manner; and
  • A general index of the principal and background documents and a description of the recordkeeping system used for cataloging and accessing those documents.

Background documents are supplemental material to support “[t]he assumptions, conclusions, and positions contained in the principal documents”. Examples of background documents include accounting records, legal agreements, projections, and invoices.

2. What is the content of the documentation that must be prepared?

a) Which transactions must be documented (all transactions with associated enterprises, or only those which exceed a particular threshold)? All transactions involving the transfer of tangible and intangible property, the provision of services, the extension of a loan or advance, and the use of property (e.g., leases and rental agreements) between related parties must be documented. The US rules and regulations do not provide thresholds or otherwise contain safe harbor provisions for small taxpayers, for example

b) What is the definition of “associated enterprises” for the purposes of this requirement?

Section 482 of the Internal Revenue Code applies a very broad definition of associated enterprises or related parties. Indeed, Treasury Regulation § 1.482-1(i) (4) defines “controlled” to include: “… any kind of control, direct or indirect, whether legally enforceable or not, and however exercisable or exercised, including control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose. It is the reality of the control that is decisive, not its form or the mode of its exercise. A presumption of control arises if income or deductions have been arbitrarily shifted”. Thus, parties can be considered to be related under Section 482 even if one party has less than 50%, or even 0%, ownership in another party.

c) For EU countries, is the content of the documentation similar to that described in the EU Code of Conduct on transfer pricing documentation for associated enterprises (“EU TPD”)? If not, are taxpayers entitled to choose between the local requirements and the EU TPD?

Not applicable.

d) Do taxpayers which are not established in your jurisdiction need to undertake to provide any specific information upon request? Can your tax authorities require the taxpayer in your jurisdiction to provide information which is located in another state?

Documentation requirements are applicable to all US taxpayers. For purposes of this discussion, “taxpayer” includes any person required to file a US tax return under US tax law. It is important to note that transfer pricing rules and regulations apply to all taxpayers so defined, not just those persons that actually file a return. As such, taxpayers are required to maintain information that pertains to related party transactions involving a US taxpayer in the form of principal and background documents, and the Internal Revenue Service may request this information. For example, a US affiliate of a foreign-based parent company is required to provide information on the parent company and any other foreign-based related parties with which the US affiliate transacts. Such information may include an organizational chart and functional analysis, financial data and projections that may impact the economic analysis, marketing materials and analyses, and accounting records.

e) If comparable studies are to be provided, do the tax authorities generally accept regional benchmark studies (e.g. pan-European benchmark studies)?

The use of regional benchmarks, such as pan-continental comparable sets, is not explicitly addressed in the US transfer pricing rules and regulations. Data on US companies is readily available, as independent, publicly-traded companies are required to file their financial statements with the Securities and Exchange Commission in a Form 10-K. In addition, there are a number of third-party databases that provide business descriptions, financial data, and other company-specific data for US companies. Such databases are commonly used to identify companies that may provide reliable benchmarks in transfer pricing matters. Thus as a practical matter US comparables are generally used to benchmark a US tested party. In practice, pan-regional comparable sets are sometimes used to test a non-US party if data on local comparables are not sufficiently available.

f) What language(s) are to be used by taxpayers in submitting the transfer pricing documentation?

While the US transfer pricing rules and regulations are silent as to the language to be used in transfer pricing documentation, in practice, documentation is prepared and submitted in English.

3. What is the deadline or timescale for providing transfer pricing documentation to the tax authorities (is it to be provided for example upon filing of the tax returns, at the beginning of a tax audit, or on the specific request of the tax authorities)?

The US maintains a contemporaneous documentation requirement, meaning that the documentation must be in existence at the time the tax return is filed. Therefore the existence of documentation alone is not sufficient to avoid penalties; taxpayers must prepare such documentation with the timely filing of the US tax return. Specifically, the principal documents numbers 1 through 8 must be prepared by the tax filing. Upon request from the Internal Revenue Service in the course of an audit, taxpayers must produce all ten principal documents within 30 days. An additional request for background documents may also be provided, which must be produced within 30 days of request.

The regulations under Section 6662 of the Internal Revenue Code contain specific penalty rules for transfer pricing misstatements. There are two types of penalties that can be imposed on an adjustment to taxable income: a transactional penalty and a net adjustment penalty. For each type of penalty, the regulations allow for either a “substantial” or a “gross” misstatement penalty depending on the severity of the tax misstatement. The penalties are calculated as a percentage of the underpayment of tax (i.e., the difference between the adjusted taxable income as determined by the Internal Revenue Service and the taxable income reported by the taxpayer). An adjustment may be excluded from penalties if the taxpayer demonstrates reasonable cause and good faith efforts, including maintaining contemporaneous documentation.

A transactional penalty is applicable if the taxpayer’s transfer prices are over – or under – stated by certain percentage thresholds. Therefore, a transactional penalty may be triggered even if the adjustment is relatively small on an absolute dollar basis. A substantial valuation misstatement is defined in Treasury Regulation § 1.6662-6: “In the case of any transaction between related persons, there is a substantial valuation misstatement if the price for any property or services (or for the use of property) claimed on any return is 200% or more (or 50% or less) of the amount determined under Section 482 to be the correct price.” In the event of a substantial valuation misstatement, the applicable transactional penalty is equal to 20% of the resultant underpayment of tax. A gross valuation misstatement occurs “… if the price for any property or services (or for the use of property) claimed on any return is 400% or more (or 25% or less) of the amount determined under Section 482 to be the correct price.” In such instances, the applicable penalty increases to 40% of the tax underpayment.

Penalties can also be triggered by the aggregate of all allocations made under Section 482 (the net adjustment penalty): “The term net Section 482 adjustment means the sum of all increases in the taxable income of a taxpayer for a taxable year resulting from allocations under Section 482 (determined without regard to any amount carried to such taxable year from another taxable year) less any decreases in taxable income attributable to collateral adjustments as described in Treasury Regulation § 1.482-1(g).” As in the transactional penalty, “substantial” and “gross” misstatement thresholds are established for the net adjustment penalty, but are based on absolute rather than relative size. A substantial valuation misstatement occurs if a net Section 482 adjustment is greater than the lesser of USD 5 million or 10% of gross receipts. In the event of a substantial valuation misstatement, the applicable penalty is equal to 20% of the resultant underpayment of tax. A gross valuation misstatement occurs “ … if a net Section 482 adjustment is greater than the lesser of USD 20 million or 20% of gross receipts.” In such instances, the applicable penalty increases to 40% of the tax underpayment.

In theory, an adjustment could trigger both a transactional and a net adjustment penalty. To address this potential taxpayer concern, the regulations under Section 6662-6(f) require coordination of penalties and do not allow the Internal Revenue Service to impose multiple penalties on the same adjustment. If an adjustment triggers both a gross valuation transactional penalty (e.g., the reported price is less than 25% of the adjusted price) and a substantial valuation net adjustment penalty (e.g., the adjustment is USD 10 million), the amount of the adjustment that is related to the gross valuation misstatement under the transactional penalty is subject to a 40% penalty, and the remaining amount of the adjustment is subject to a 20% penalty. If an adjustment were to trigger both a substantial transactional penalty and a gross valuation net adjustment penalty (e.g., the adjustment is greater than USD 20 million), the entire amount is subject to the net adjustment penalty of 40%; no portion would be subject to a 20% penalty.

5. Does the absence or incompleteness of documentation reverse the burden of the proof as regards the arm’s length character of the transactions?

The Internal Revenue Service is granted broad discretion in transfer pricing cases. Section 482 of the Internal Revenue Code provides that the Internal Revenue Service “… may distribute, apportion, or allocate gross income, deductions, credits, or allowances … if … such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect … income.” Thus, the burden of proof rests with the taxpayer, regardless of whether or not documentation is prepared. In general, to avoid a transfer pricing adjustment, a taxpayer must prove that the adjustment initiated by the Internal Revenue Service was “arbitrary, capricious or unreasonable” and that the disputed transaction satisfies the arm’s length standard under Treasury Regulation § 1.482-1(b).

In the US, taxpayers are not prevented from seeking Competent Authority relief as specified in the mutual agreement procedure provisions of applicable tax treaties in the event of a transfer pricing adjustment, irrespective of whether the proposed adjustment would imply a penalty. Competent Authority relief may not alleviate documentation-related penalties, however. For example, if an adjustment initiated by the Internal Revenue Service included a penalty, the Competent Authority process can eliminate the penalty only if the settlement results in an adjustment below the thresholds described in Sections 6662(e) and 6662(h) of the Internal Revenue Code. Otherwise a potential penalty will be evaluated in reference to the adjustment amount as determined in the settlement.

Michael Heimert
Duff & Phelps, LLC
Jessica Joy
Duff & Phelps, LLC