Recent IRS Statements and Guidance
On 15 November 2022, at the American Bar Association Section of Taxation’s Philadelphia Tax Conference, acting commissioner of the IRS Large Business and International (LB&I) Division, Holly Paz, suggested that the IRS plans to apply the economic substance doctrine more frequently in transfer pricing disputes. Paz stated that, in the wake of recent IRS “success” in litigating transfer pricing cases, “[w]e are thinking about economic substance, of sham transactions, and also assertion of penalties.”
Paz’s remarks came two weeks after her warning, at the American Institute of CPAs National Tax Conference, that taxpayers should expect the IRS to increasingly assert penalties in transfer pricing disputes. And earlier, in an April 2022 LB&I Memorandum (LB&I‑04‑0422‑0014), the IRS lifted a longstanding requirement that revenue agents secure “executive-level” approval before applying the economic substance doctrine and related penalties.
To aid examiners considering asserting the economic substance doctrine, the April 2022 LB&I Memorandum identified numerous factors that “tend to show that application of the economic substance doctrine may be appropriate[,]” including that the relevant transaction:
- is highly structured;
- includes unnecessary steps;
- is not at arm’s length with unrelated third parties;
- creates no meaningful economic change on a present value basis (pre-tax); and
- has no credible business purpose apart from federal tax benefits.
The factors largely mirror those in the IRS’s now decade old economic substance guidance (LB&I‑4‑0711‑015, 7/15/11). However, the April 2022 LB&I Memorandum notably removed as a factor that the relevant transaction is promoted, developed, or administered by a tax department or outside advisors. No rationale is provided for the factor’s removal.
The Economic Substance Doctrine and Its Application to Transfer Pricing Disputes
The economic substance doctrine began as a judicially created anti-abuse doctrine designed to disregard certain tax-motivated transactions that complied with a literal reading of the Internal Revenue Code, but were inconsistent with what Congress had intended. In its pre-codified form, the doctrine generally required transactions to satisfy two prongs: objective economic substance and subjective business purpose. See, e.g., Frank Lyon Co. v. United States, 435 U.S. 561 (1978).
Congress codified the economic doctrine as section 7701(o), as part of the Health Care and Education Reconciliation Act of 2010 (“2010 Act”). Under the codified economic substance doctrine, transactions have economic substance if: (1) “the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position,” and (2) “the taxpayer has substantial purpose (apart from Federal income tax effects) for entering into such transaction.” (emphasis added).
The IRS has, historically, sparingly applied the economic substance doctrine in transfer pricing cases. Indeed, Congress envisioned section 7701(o) operating separately from section 482. In both the House Report for the 2010 Act, and in the Joint Committee on Taxation report, Congress created a so-called “Angel List” that purportedly immunized certain transactions from the economic substance doctrine. One of the examples on the list is “[t]he choice to utilize a related-party entity in a transaction, provided that the arm’s length standard of section 482 and other applicable concepts are satisfied.” Congress, therefore, recognized that the IRS was already sufficiently empowered to address related party transactions through section 482 and that section 7701(o) was operationally separate.
Recent transfer pricing cases have, however, apparently emboldened the IRS to test the limits, or expand the contours of the economic substance doctrine. Perrigo provides a potential study of the IRS’s embryonic transfer pricing strategy. The case arose from L Perrigo Company’s 2006 assignment of rights under a 2005 unrelated party contract to controlled parties. The IRS argued that this assignment lacked economic substance and, only in the alternative, that the assignment was not priced at arm’s length under section 482. The IRS, therefore, upended the section 482 framework, which already integrates economic substance principles (see Treas. Reg. § 1.482-1(d)(3)(ii)(B)), to more facilely apply the economic substance doctrine’s flexible approach outside of the section 482 regime. Perrigo is an ongoing case; the district court will ultimately have to harmonize the competing regimes and approaches. And while the precedential value of any determination by the district court may be limited to its jurisdiction, it will be a bellwether for controversies in exam, IRS Appeals, and other forums.
Economic Substance Penalties in Transfer Pricing Disputes
The IRS’s transfer pricing saber-rattling has extended further to accuracy-related penalties. Paz’s comments that the IRS will more actively assert penalties in transfer pricing cases and the April 2022 LB&I Memorandum’s discharge of executive-level approval for economic substance-related penalties frame the IRS’s increasingly offensive posture.
The economic substance penalty regime is mechanical and notoriously unforgiving. Under section 6662(b)(6), the IRS may assert a 20% penalty on underpayments arising from transactions lacking economic substance under section 7701(o). The penalty is increased to 40% if the relevant transactions are not properly disclosed on a tax return (on Forms 8275 or 8275-R). Sections 6662(i)(1) and (2). There is no reasonable cause and good faith penalty defense for economic substance penalties: “outside opinions or in-house analysis would not protect a taxpayer from imposition of a penalty if it is determined that the transaction lacks economic substance or fails to meet the requirements of any similar rule of law.” See H.R. Rep. No. 111‑443, at 304 (2010). Accordingly, the IRS may assert economic substance penalties irrespective of the taxpayer’s thorough, contemporaneous documentation (including transfer pricing documentation) explaining its business purpose for the relevant transactions or the taxpayer’s reasonable reliance on advisors.
The IRS’s evolving strategy for transfer pricing disputes, and willingness to develop new arguments in those cases, show that those matters remain in the agency’s crosshairs. Tax departments will need to adjust to address the IRS’s du jour position and more thoroughly explain to Exam the business purposes of their intercompany transactions and supply chains. Tax departments should also be leery of the IRS conflating section 482’s realistic alternative principles with the economic substance doctrine. The economic substance doctrine should not be triggered merely because the taxpayer could have structured a transaction differently.
Tax departments should also continue to maintain robust, contemporaneous transfer pricing documentation. That documentation should, in light of the IRS’s warnings, elaborate more fully on complex transactions’ or structures’ business purpose(s). Because that documentation is reviewed early in an examination, it may prevent IRS misunderstandings that can cascade through the audit.