Transfer Pricing Economic Substance

In April of this year, the IRS released a memorandum announcing a change to IRS policy regarding the economic substance doctrine in audits. This memorandum lowered the threshold for the IRS to levy penalties under the economic substance doctrine, requiring revenue agents to obtain approval from a direct supervisor instead of the previously required executive approval. The memorandum also listed the circumstances under which applying the economic substance doctrine may be appropriate. Examples include (1) a transaction being highly structured, (2) a transaction including unnecessary steps, (3) an artificial limitation on gain or loss and (4) a transaction generating a deduction that is not matched by an equivalent economic loss or expense.

Recent developments have seen Holly Paz, Acting Commissioner of the IRS’s Large Business and International (LB&I) Division, announce that the IRS will more frequently apply the economic substance doctrine in transfer pricing audits. Given the lower threshold for penalty assessment under the economic substance doctrine and the increased frequency of its application in transfer pricing matters, it is imperative that taxpayers analyze their current transfer pricing practices to ensure their intercompany transactions meet the IRS’s economic substance doctrine, codified in IRC Section 7701(o).

To meet the economic substance doctrine taxpayers’ related party transactions should (1) have a meaningful economic impact other than federal income tax effects, and (2) taxpayers should have a substantial purpose for entering the transaction other than for federal income tax purposes. This economic substance should be proven in any transfer pricing study a taxpayer completes. Taxpayers failing to meet this threshold for economic substance expose themselves to penalties from an IRS with an increased budget, a tighter focus on transfer pricing enforcement, and a lower threshold for penalties relating to economic substance.

Given this changing transfer pricing landscape and the increased compliance requirements coming with it, it is imperative that taxpayers consult with Transfer Pricing and International Tax professionals when considering any related party transactions, whether they be new transactions or transactions the taxpayer has been engaged in for years. These professionals can help ensure taxpayers have robust transfer pricing documentation, demonstrating the economic substance of their intercompany transactions, and meeting the increasing IRS compliance requirements associated with transfer pricing.

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