Transfer Pricing Penalty Regs Issued

 [4830-01-u]

 ACTION: Temporary Regulations.

 SUMMARY: These amendments to the regulations under 26 CFR part 1 provide guidance in the imposition of the accuracy-related penalty under Internal Revenue Code sections 6662(e) and (h) and section 6664(c) for transactions between persons described in Internal Revenue Code section 482 and net section 482 transfer price adjustments. This action is necessary because of changes to the applicable tax laws made by the Omnibus Budget Reconciliation Act of 1993.

 EFFECTIVE DATE: These regulations are effective February 2, 1994.

 These regulations apply to taxable years beginning after December 31, 1993.

 FOR FURTHER INFORMATION CONTACT: Thomas L. Ralph at (202) 622-3880 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

This regulation is being issued without prior notice and public procedure pursuant to the Administrative Procedure Act (5 U.S.C. 553). For this reason, the collection of information contained in this regulation has been reviewed and, pending receipt and evaluation of public comments, approved by the Office of Management and Budget (OMB) under control number 1545-1365. The estimated annual burden per recordkeeper varies from 5 hours to 15 hours, depending on individual circumstances, with an estimated average of 10 hours.

 These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual recordkeepers may require greater or less time, depending on their particular circumstances.

 For further information concerning this collection of information, and where to submit comments on this collection of information, the accuracy of the estimated burden, and suggestions for reducing this burden, please refer to the preamble in the cross- referencing notice of proposed rulemaking published in the Proposed Rules section of this issue of the Federal Register.

BACKGROUND

 On January 21, 1993, the IRS published a notice of proposed rulemaking in the Federal Register (58 FR 5263) that proposed amendments to the Income Tax Regulations under sections 6662(e) and (h) and section 6664(c) of the Internal Revenue Code of 1986 (Code), as amended. Those proposed regulations implemented section 11312 of the Omnibus Budget Reconciliation Act of 1990, Pub. L. 101-508, 104 Stat. 1388. Comments responding to the notice of proposed rulemaking were received and a public hearing was held on May 14, 1993. Section 13236 of the Omnibus Budget Reconciliation Act of 1993 (Pub. L. 103-66, 107 Stat. 312) further amended sections 6662(e) and (h) of the Code. After consideration of all comments received and pursuant to the statutory changes, the IRS has withdrawn the previous proposed regulations and adopts this Treasury decision.

EXPLANATION OF PROVISIONS

 The principal purpose of these regulations is to set forth rules implementing the imposition of accuracy-related penalties in the context of section 482. The exceptions from the penalty imposed under section 6662(e) in the case of certain net section 482 transfer pricing adjustments are a key component of these rules are. [sic] Reflecting the amendments to the statute pursuant to section 13236 of the Omnibus Budget Reconciliation Act of 1993, the regulations provide a two-part exception from the imposition of the penalty with respect to such adjustments, depending on whether the taxpayer used a specified or unspecified method under the regulations under section 482. If the taxpayer used a specified method, the taxpayer must have reasonably concluded, based on the available data and the potentially applicable alternative specified methods, that its application of the selected method resulted in the most accurate measure of an arm's length result. Thus, if the taxpayer reasonably concluded that a different specified method would result in a more accurate measure of an arm's length result than the selected method, the taxpayer would not satisfy the requirements of this exception. If the taxpayer used an unspecified method, the taxpayer generally must have reasonably concluded, based on the available data, that none of the specified methods was likely to achieve ar arm's length result and that the method used was likely to achieve such a result.

 Finally, irrespective of the method selected, the taxpayer must have prepared documentation articulating the required analysis at the time that the tax return was filed, and provide such documentation to the Internal Revenue Service within 30 days of a request for such documentation.

THE NEED FOR TRANSFER PRICING ANALYSIS AND DOCUMENTATION

 The arm's length standard seeks to mirror the results obtained by unrelated parties in their business dealings. Unrelated parties analyze the value of property or services prior to selling or buying such property or services in the open market. However, transactions between related parties do not involve the transfer of goods outside of the related party group. A transfer price will not affect the total profit ultimately realized by the group but may affect total tax liability. To ensure that the transfer price a taxpayer reports on its income tax return is determined in a manner consistent with the arm's length standard, section 6662(e) encourages a taxpayer engaged in related party transactions to prepare a factual and economic analysis based on reasonably available related party and third party market data that substantiates the price chosen, and to maintain appropriate documentation of that analysis.

 The experience of the IRS has been that the majority of taxpayers do not provide an explanation of how their intercompany pricing was established. In many cases examiners' access to a corporation's transfer pricing information is delayed or denied. Moreover, many taxpayers do not rely upon any form of comparables or other contemporaneous information either in planning or in defending intercompany transactions. The taxpayer, not having attempted to structure the transaction in accordance with the arm's length standard, seeks to defend its position on examination by finding whatever uncontrolled transaction or transfer pricing method provides a result that most closely approximates the result initially reported. The failure by taxpayers to analyze their intercompany pricing prior to audit increases controversy between taxpayers and the IRS, as both seek to develop post hoc analyses of the arm's length character of the transactions. Thus, the failure to apply the arm's length standard in setting prices for controlled transactions (and the lack of contemporaneous documentation explaining that application) increases the time spent and expense incurred by both the taxpayer and the IRS in determining whether that result was consistent with the arm's length standard. Accordingly, these regulations are designed to encourage taxpayers to make a serious effort to comply with the arm's length standard, report an arm's length result on their income tax return, document their transfer pricing analyses, and provide that documentation to the IRS upon request.

STATUTORY REQUIREMENTS

 Section 6662(a) imposes a penalty in the amount of 20 percent of any underpaynent to which the section applies. Section 6662(b) lists the types of underpayments to which section 6662(a) applies. One such underpayment is an underpayment attributable to any substantial valuation misstatement under chapter 1 of the Code.

 Section 6662(e) defines a substantial valuation misstatement. These temporary regulations under section 6662(e) contain the rules for determining whether there is a substantial valuation misstatement attributable to section 482 allocations. A substantial valuation misstatement exists if (1) the transfer price for any property or services (or for the use of property) claimed on a return is 200 percent or more (or 50 percent or less) of the amount determined under section 482 to be the arm's length amount (the transactional penalty), or (2) the net section 482 adjustment exceeds the lesser of five million dollars or ten percent of gross receipts (the net adjustment penalty).

 Section 6662(h) increases the amount of the penalty to 40 percent for both the transactional and the net adjustment penalties in the case of a gross valuation misstatement. There is a gross valuation misstatement if (1) the price for any property or services (or for the use of property) claimed on any return in connection with any transaction between persons described in section 482 is 400 percent or more (or 25 percent or less) of the amount determined under section 482 to be the arm's length amount, or (2) the net section 482 adjustment exceeds the lesser of twenty million dollars or twenty percent of gross receipts.

AMOUNTS EXCLUDED FROM A NET SECTION 482 ADJUSTMENT

 An amount is excluded from the calculation of a net section 482 adjustment if the requirements of section 1.6662-6T(d)(2), (3), or (4) are met with respect to that amount. If a taxpayer meets the requirements of paragraph (d) of these regulations with respect to some, but not all of the allocations made under section 482, then for purposes of determining the net section 482 adjustment, setoffs, as taken into account under section 1.482-1T(e)(5), must be applied ratably against all such allocations.

SPECIFIED METHOD APPLIED

 Paragraph (d)(2) provides that an adjustment will be excluded from the calculation of a net section 482 adjustment if the taxpayer satisfies the specified method requirement of paragraph (d)(2)(ii) and the documentation requirement of paragraph (d)(2)(iii). A taxpayer will meet the specified method requirement if the taxpayer selects and applies a method specified in the section 482 regulations in a reasonable manner. A method is a specified method if it is described in the regulations under section 482. With respect to transfers of tangible property, these methods currently include the comparable uncontrolled price method, resale price method, cost-plus method, and comparable profits method. With respect to transfers of intangible property these methods currently include the comparable uncontrolled transactions method and comparable profits method. A bona fide cost sharing arrangement under section 1.482-2A(d)(4) is considered a specified method.

 Unspecified methods are methods other than specified methods. The profit split method, under section 1.482-6 of the proposed regulations and qualified cost sharing arrangements, under section 1.482-2(g) of the proposed regulations, will become specified methods if and when regulations describing those methods are finalized. A taxpayer will ordinarily not be considered to have applied an unspecified method merely because it failed to make an adjustment in the application of a specified method. However, the failure to make adjustments is relevant to the reasonableness of the application of that method. The selection and application of a method are reasonable only if, given the available data and the potentially available methods, the taxpayer reasonably concluded that the method (and its application of that method) provided the most accurate measure of an arm's length result under the principles of the best method rule in section 1.482-1T(b)(2)(iii).

 The specified method standard differs from the more likely than not be sustained on the merits standard set forth in proposed regulations issued on January 21, 1993. This change reflects the amendments made by section 13236 of the Omnibus Budget Reconciliation Act of 1993 (Pub. L. 103-66, 107 Stat. 312) to section 6662(e), under which a section 482 adjustment is to be excluded from the calculation of a net section 482 adjustment if the taxpayer reasonably applied one of the specified section 482 methods (and satisfied the documentation requirements described below). In selecting the method to apply, a taxpayer should select the specified method that is most appropriate under the facts and circumstances. Thus, the taxpayer must reasonably conclude that its application of the transfer pricing method chosen will provide the most accurate measure of an arm's length result under the facts and circumstances of the transaction under review. The application of a specified method will not satisfy this standard if the taxpayer concluded, or should have concluded, that a reasonable application of another specified method would provide a more accurate arm's length result than the method chosen. For example, a taxpayer might not satisfy this standard if the taxpayer applied the comparable profits method to determine its prices but the taxpayer had data relating to a comparable uncontrolled transaction involving substantially similar conditions. Given the guidance set forth in the section 482 regulations and the existence of closely comparable data, a conclusion that a different analysis would provide a more accurate measure of an arm's length result, ordinarily would not be reasonable.

 A taxpayer's analysis of its transfer prices must include the most current data that is available at the time that the taxpayer files its tax return. These regulations require that taxpayers perform a reasonably thorough search for data. However, this data may not reflect transactions in the current taxable year. Accordingly, it may be necessary for taxpayers to make compensating adjustments to reflect changes in the data between the time that prices were set for the year and the time that the return is filed.

FACTORS

 The regulations discuss several nonexclusive factors that are to be taken into account in determining whether the taxpayer reasonably concluded that its application of the method selected would provide the most accurate measure of an arm's length result. The first factor is that a taxpayer's experience and knowledge in transfer pricing will be relevant in determining how thorough and precise the taxpayer's analysis must be. In assessing the experience and knowledge of the taxpayer, the experience and knowledge of the controlled group is taken into account, rather than the experience and knowledge of any member of the controlled group. Thus, the larger and more sophisticated a controlled group of corporations, the more thorough and precise its analysis should be.

 The second factor is the extent to which sufficient accurate data is available to apply a method reasonably. A taxpayer is obligated to engage in a reasonably thorough search for comparable transactions and other data necessary to apply the methods under section 482. A factor to consider in determining whether a search for data is reasonably thorough is the cost of searching for the data in relation to the dollar amount of the intercompany transaction in question. For example, a taxpayer need not obtain data regarding a comparable uncontrolled transaction if the intercompany transaction had a value of $50,000 and the search for and analysis of the data will cost $25,000. Alternatively, if necessary to reasonably apply a specified method, it ordinarily would be reasonable to expect that a taxpayer would incur a similar expense to search for and analyze data if the taxpayer is engaged in intercompany transactions with a dollar amount of $250 million. If a taxpayer's analysis neglected data that it would have been expected to obtain under the above criteria, then the analysis would not be considered reasonable.

 The third factor is the extent to which a taxpayer follows the relevant requirements set forth in regulations under section 482. Furthermore, in applying the selected method, the extent to which the taxpayer makes all the adjustments necessary to reasonably conclude that its application of the method chosen would provide the most accurate measure of an arm's length result will be taken into account.

 The fourth factor is the extent to which the taxpayer relied on the advice of a qualified professional. The extent to which reliance is appropriate will depend on the qualifications of the professional and the quality of the study or other advice that is rendered, rather than the relationship that the professional has to the taxpayer.

UNSPECIFIED METHOD APPLIED

 Paragraph (d)(3) provides that an adjustment will be excluded from the calculation of a net section 482 adjustment if the taxpayer satisfies the unspecified method requirement of paragraph (d)(3)(ii) and the documentation requirement of paragraph (d)(3)(iii). The unspecified method requirement is met if a method other than a specified method was applied and the requirements of paragraph (d)(3)(ii)(B) or (C) are met, as appropriate.

 Paragraph (d)(3)(ii)(B) provides that if the transaction is of a type for which there are specified methods, then a taxpayer will be considered to have met the unspecified method requirement if the taxpayer reasonably concludes that, given the available data, none of the specified methods was likely to provide an accurate measure of an arm's length result, and that it selected and applied an unspecified method in a way that would likely provide an accurate measure of an arm's length result, given the available data.

 Paragraph (d)(3)(ii)(C) provides that if the transaction is of a type for which there are no specified methods, then a taxpayer will be considered to have met the unspecified method requirement if it selected and applied an unspecified method in a reasonable manner. A taxpayer's selection and application is reasonable if the taxpayer reasonably concludes that the method (and its application of that method) provided the most accurate measure of an arm's length result under the principles of the best method rule in section 1.482-1T(b)(2)(iii).

DOCUMENTATION REQUIREMENT

 An examiner cannot effectively examine a taxpayer's transfer pricing without adequate documentation setting forth the basic transfer pricing analysis conducted by the taxpayer. Accordingly, the documentation requirement does not provide a long, rigid list of documents that must be maintained; rather it focuses on the type of information necessary to evaluate how the taxpayer determined its transfer prices. The documentation requirements are essentially the same regardless of whether the taxpayer uses a specified method or an unspecified method. They diverge only in what the documentation must establish rather than the type of information that must be maintained. A taxpayer that uses a specified method must maintain sufficient documentation (that is in existence when the return is filed) to establish that it met the specified method requirement. A taxpayer that uses an unspecified method must maintain sufficient documentation (that is in existence when the return is filed) to establish that it met the unspecified method requirement. Regardless of the method used by the taxpayer, it must provide that documentation to the IRS within 30 days of a request.

 The temporary regulations set forth two classifications of documentation -- principal and background documents. Principal documents consist of the basic transfer pricing analysis conducted by the taxpayer. Background documents are documents that typically support the principal documents. Only principal documents must be provided upon the IRS's request for principal documents. However, both types of documentation must be produced within thirty days of a request.

 A district director has discretion to extend the period for producing principal documents only if the taxpayer has made a minor or inadvertent failure to provide the required documents, has otherwise made a good faith effort to comply, and remedies the failure when it becomes known. For background documents, a district director has discretion to extend the production period for a short period.

FOREIGN-TO-FOREIGN TRANSACTIONS

 Finally, paragraph (d)(4) provides that adjustments that are attributable to a transaction between foreign corporations are also excluded from the calculation of a net section 482 adjustment, unless the treatment of that transaction affects the determination of U.S. source income or taxable income that is effectively connected with the conduct of a trade or business within the United States.

CARRYOVERS AND CARRYBACKS

 The regulations contain a special rule concerning tax benefits, such as losses, deductions, or credits, that may be carried to another taxable year. If a taxpayer's substantial or gross valuation misstatement gives rise to such a tax benefit that is carried to another taxable year, then the penalty will be imposed on any resulting underpayment of tax attributable to such a tax benefit in that other taxable year. In determining whether there is a substantial or gross valuation misstatement for a taxable year, no amount carried from another taxable year shall be included.

COORDINATION RULES

 The coordination rules remain substantively unchanged from the proposed regulations issued on January 21, 1993. These regulations provide rules for coordinating imposition of the transactional penalty and the net adjustment penalty.

ADVANCE PRICING AGREEMENTS

 If a transfer pricing methodology is developed and applied pursuant to an Advance Pricing Agreement in any tax year, that methodology may reasonably be relied upon in the current year if the relevant facts and circumstances have not changed or if the methodology has been appropriately modified to reflect any changes in facts and circumstances.

EFFECTIVE DATE

 These regulations apply to taxable years beginning after December 31, 1993. For taxable years ending after November 5, 1990, but beginning prior to January 1, 1994, the Treasury Department considers the proposed regulations issued on January 21, 1993, to be a reasonable interpretation of sections 6662(e) and (h), except that no requirement of contemporaneous documentation may be imposed for transactions prior to April 21, 1993. In any case, contemporaneous documentation may be helpful in establishing that the taxpayer had reasonable cause and acted in good faith.

SPECIAL ANALYSES

 It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, an initial Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, an initial Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, these temporary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Thomas L. Ralph of the Office of the Associate Chief Counsel (International), Internal Revenue Service. However, other personnel from the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS IN 26 CFR PART 1

 Income taxes, Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Sections 1.6662-5 and 1.6662-6T also issued under 26 U.S.C. 6662. * *

Par. 2. Section 1.6662-0 is amended by:

1. Adding the entries for section 1.6662-5T.

2. Adding the entries for section 1.6662-6T.

3. The additions read as follows:

SECTION 1.6662-0 TABLE OF CONTENTS. * * *

* * * * *

 SECTION 1.6662-5T SUBSTANTIAL AND GROSS VALUATION MISSTATEMENTS UNDER CHAPTER 1

SECTION 1.6662-5T SUBSTANTIAL AND GROSS VALUATION MISSTATEMENTS UNDER CHAPTER 1 (TEMPORARY).

(a) through (d) [Reserved]

(e) DEFINITIONS -- (1) SUBSTANTIAL VALUATION MISSTATEMENT. There is a substantial valuation misstatement if --

(i) 200 PERCENT TEST. The value or adjusted basis of any property claimed on a return of tax imposed under chapter 1 of the Internal Revenue Code is 200 percent or more of the correct amount; or

(ii) TESTS RELATED TO SECTION 482. There is a misstatement described in section 1.6662-6T(b)(1) or (c)(1) (concerning substantial valuation misstatements pertaining to transactions between related persons).

(2) GROSS VALUATION MISSTATEMENT. There is a gross valuation misstatement if --

(i) 400 PERCENT TEST. The value or adjusted basis of any property claimed on a return of tax imposed under chapter 1 of the Internal Revenue Code is 400 percent or more of the correct amount; or

(ii) TESTS RELATED TO SECTION 482. There is a misstatement described in section 1.6662-6T(b)(2) or (c)(2) (concerning gross valuation misstatements pertaining to transactions between related persons).

(3) PROPERTY. For purposes of this section, the term property refers to both tangible and intangible property. Tangible property includes property such as money, land, buildings, fixtures, and inventory. Intangible property includes property such as goodwill, covenants not to compete, leaseholds, patents, contract rights, debts, choses in action, and any other item of intangible property described in section 1.482-4T(b).

(f) through (i) [Reserved]

(j) TRANSACTIONS BETWEEN PERSONS DESCRIBED IN SECTION 482 AND NET SECTION 482 TRANSFER PRICE ADJUSTMENTS. For rules relating to the penalty imposed with respect to a substantial or gross valuation misstatement arising from a section 482 allocation, see section 1.6662-6T.

Par. 4. Section 1.6662-6T is added to read as follows:

SECTION 1.6662-6T TRANSACTIONS BETWEEN PERSONS DESCRIBED IN SECTION 482 AND NET SECTION 482 TRANSFER PRICE ADJUSTMENTS.

(a) IN GENERAL -- (1) PURPOSE AND SCOPE. Pursuant to section 6662(e) a penalty is imposed on any underpayment attributable to a substantial valuation misstatement pertaining to either a transaction between persons described in section 482 (the transactional penalty) or a net section 482 transfer price adjustment (the net adjustment penalty). The penalty is equal to 20 percent of the underpayment of tax attributable to that substantial valuation misstatement. Pursuant to section 6662(h) the penalty is increased to 40 percent of the underpayment in the case of a gross valuation misstatement with respect to either penalty. Paragraph (b) of this section provides specific rules related to the transactional penalty. Paragraph (c) of this section provides specific rules related to the net adjustment penalty, and paragraph (d) of this section describes amounts that will be excluded for purposes of calculating the net adjustment penalty. Paragraph (e) of this section sets forth special rules in the case of carrybacks and carryovers. Paragraph (f) of this section provides coordination rules between penalties. Paragraph (g) of this section provides the effective date of this section.

(2) REPORTED RESULTS. Whether an underpayment is attributable to a substantial or gross valuation misstatement must be determined from the results of controlled transactions that are reported on an income tax return, regardless of whether the amount reported differs from the transaction price initially reflected in the taxpayer's books and records. The results of controlled transactions that are reported on an amended return will be used only if the amended return is filed before the Internal Revenue Service has contacted the taxpayer regarding the corresponding original return. A written statement furnished by a taxpayer subject to the Coordinated Examination Program will be considered an amended return for purposes of this section if it satisfies either the requirements of a qualified amended return for purposes of section 1.6664-2(c)(3) or such requirements as the Commissioner may prescribe by revenue procedure. In the case of a taxpayer that is a member of a consolidated group, the rules of this paragraph (a)(2) apply to the consolidated income tax return of the group.

(3) IDENTICAL TERMS USED IN SECTION 482 REGULATIONS. For purposes of this section, the terms used in these regulations shall have the same meaning as identical terms used in regulations under section 482.

(b) THE TRANSACTIONAL PENALTY -- (1) SUBSTANTIAL VALUATION MISSTATEMENT. 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 percent or more (or 50 percent or less) of the amount determined under section 482 to be the correct price.

(2) GROSS VALUATION MISSTATEMENT. In the case of any transaction between related persons, there is a gross valuation misstatement if the price for any property or services (or for the use of property) claimed on any return is 400 percent or more (or 25 percent or less) of the amount determined under section 482 to be the correct price.

(3) REASONABLE CAUSE AND GOOD FAITH. Pursuant to section 6664(c), the transactional penalty will not be imposed on any portion of an underpayment with respect to which the requirements of section 1.6664-4 are met. A taxpayer that meets the requirements of paragraph (d) of this section with respect to an allocation under section 482 will be treated as having established that there was reasonable cause and good faith with respect to that item for purposes of section 1.6664-4. If a substantial or gross valuation misstatement under the transactional penalty also constitutes (or is part of) a substantial or gross valuation misstatement under the net adjustment penalty, then the rules of section (d) (and not the rules of section 1.6664-4) will be applied to determine whether the adjustment is excluded from calculation of the net section 482 adjustment.

(c) NET ADJUSTMENT PENALTY -- (1) NET SECTION 482 ADJUSTMENT. For purposes of this section, 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 section 1.482-1T(e). For purposes of this section, amounts that meet the requirements of paragraph (d) of this section will be excluded from the calculation of the net section 482 adjustment. Substantial and gross valuation misstatements that are subject to the transactional penalty under paragraphs (b)(1) or (2) are included in determining the amount of the net section 482 adjustment. See paragraph (f) of this section for coordination rules between penalties.

(2) SUBSTANTIAL VALUATION MISSTATEMENT. There is a substantial valuation misstatement if a net section 482 adjustment is greater than the lesser of 5 million dollars or ten percent of gross receipts.

(3) GROSS VALUATION MISSTATEMENT. There is a gross valuation misstatement if a net section 482 adjustment is greater than the lesser of 20 million dollars or twenty percent of gross receipts.

(4) SETOFF ALLOCATION RULE. If a taxpayer meets the requirements of paragraph (d) of this section with respect to some, but not all of the allocations made under section 482, then for purposes of determining the net section 482 adjustment, setoffs, as taken into account under section 1.482-1T(e)(5), must be applied ratably against all such allocations. The following example illustrates the principle of this paragraph (c)(4).

EXAMPLE. (i) The Internal Revenue Service makes the following section 482 adjustments for the taxable year:

 1) $ 9,000,000

(5) GROSS RECEIPTS. For purposes of this section, gross receipts must be computed pursuant to the rules contained in section 1.448-1T(f)(2)(iv), as adjusted to reflect allocations under section 482.

(6) COORDINATION WITH REASONABLE CAUSE EXCEPTION UNDER SECTION 6664(c). Pursuant to section 6662(e)(3)(D), a taxpayer will be treated as having reasonable cause under section 6664(c) for any portion of an underpayment attributable to a net section 482 adjustment only if the taxpayer meets the requirements of paragraph (d) of this section with respect to that portion.

(7) EXAMPLES. The principles of this paragraph (c) are illustrated by the following examples.

EXAMPLE 1. (i) The Internal Revenue Service makes the following section 482 adjustments for the taxable year:

 1) $ 2,000,000           (attributable to an increase in

EXAMPLE 2. (i) The Internal Revenue Service makes the following section 482 adjustments for the taxable year:

 1) $11,000,000

EXAMPLE 3. (i) The Internal Revenue Service makes the following section 482 adjustments to the income of an affiliated group that files a consolidated return for the taxable year:

 1) $ 1,500,000      (attributable to Member A)

EXAMPLE 4. (i) The Internal Revenue Service makes the following section 482 adjustments to the income of an affiliated group that files a consolidated return for the taxable year:

 1) $ 1,500,000      (attributable to Member A)

EXAMPLE 5. (i) The Internal Revenue Service makes the following section 482 adjustments to the income of an affiliated group that files a consolidated return for the taxable year:

 1) $ 2,000,000      (attributable to Member A)

(d) AMOUNTS EXCLUDED FROM NET SECTION 482 ADJUSTMENTS -- (1) IN GENERAL. An amount is excluded from the calculation of a net section 482 adjustment if the requirements of paragraph (d)(2), (3), or (4) of this section are met with respect to that amount.

(2) APPLICATION OF A SPECIFIED SECTION 482 METHOD -- (i) IN GENERAL. An amount is excluded from the calculation of a net section 482 adjustment if the taxpayer establishes that both the specified method and documentation requirements of this paragraph (d)(2) are met with respect to that amount. For purposes of this paragraph (d), a method will be considered a specified method if it is described in the regulations under section 482 and the method applies to transactions of the type under review. A bona fide cost sharing arrangement is considered a specified method. See section 1.482-2A(d)(4). An unspecified method is not considered a specified method. See section 1.482-3T(e) and section 1.482-4T(d).

(ii) SPECIFIED METHOD REQUIREMENT. The specified method requirement is met if the taxpayer selects and applies a specified method in a reasonable manner. The taxpayer's selection and application of a specified method is reasonable only if, given the available data and the applicable pricing methods, the taxpayer reasonably concluded that the method (and its application of that method) provided the most accurate measure of an arm's length result under the principles of the best method rule in section 1.482-1T(b)(2)(iii). For examples illustrating the selection of a specified method consistent with this paragraph (d)(2)(ii), see section 1.482-1T(b)(2)(iii)(C). An application of a specified method provides the most accurate measure of an arm's length result if it provides a more accurate measure of an arm's length result than any alternative specified method and any alternative application of the method chosen. Thus, it is not necessary for a taxpayer to conclude that the selected specified method provides a more accurate measure of an arm's length result than any unspecified method. Whether the taxpayer's conclusion was reasonable must be determined from all the facts and circumstances. The factors relevant to this determination include the following:

(A) The experience and knowledge of the taxpayer, including all members of the taxpayer's controlled group.

(B) The extent to which accurate data was available and the data was analyzed in a reasonable manner. A taxpayer must engage in a reasonably thorough search for the data necessary to determine which method should be selected and how it should be applied. Furthermore, a taxpayer must use the most current reliable data that is available before the return is filed. In this regard, the expense of collecting data relative to the dollar amount of the transactions in question is a factor that may be taken into account in determining the scope of a reasonably thorough search for data.

(C) The extent to which the taxpayer followed the relevant requirements set forth in regulations under section 482 with respect to the application of the method.

(D) The extent to which the taxpayer reasonably relied on the analysis of, or a study done by, a professional qualified to conduct such an analysis or study, including an attorney, accountant, or economist. Whether the professional is an employee of, or related to, the taxpayer is not determinative in evaluating the reliability of that analysis or study, as long as the analysis or study is objective, thorough, and well reasoned. Such reliance is reasonable only if the taxpayer disclosed to the professional all relevant information regarding the controlled transactions at issue. A transfer pricing study or analysis that was reasonably relied upon in a prior year may reasonably be relied upon in the current year if the relevant facts and circumstances have not changed or if the study or analysis has been appropriately modified to reflect any change in facts and circumstances.

(iii) DOCUMENTATION REQUIREMENT -- (A) IN GENERAL. The documentation requirement of this paragraph (d)(2)(iii) is met if the taxpayer maintains sufficient documentation to establish that the taxpayer reasonably concluded that, given the available data and the applicable pricing methods, the method (and its application of that method) provided the most accurate measure of an arm's length result under the principles of the best method rule in section 1.482-1T(b)(2)(iii), and provides that documentation to the Internal Revenue Service within 30 days of a request for it. That documentation must be in existence when the return is filed. The district director may, in his discretion, excuse a minor or inadvertent failure to provide required documents, but only if the taxpayer has made a good faith effort to comply, and the taxpayer promptly remedies the failure when it becomes known. The required documentation is divided into two categories, principal and background documents, as described in paragraphs (d)(2)(iii)(B) and (C) of this section.

(B) PRINCIPAL DOCUMENTS. The principal documents should accurately and completely describe the basic transfer pricing analysis conducted by the taxpayer. The documentation must include the following --

(1) 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;

(2) 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;

(3) Any documentation explicitly required by the regulations under section 482;

(4) A description of the specified method selected and an explanation of why that method was selected;

(5) A description of the unspecified methods that were considered and an explanation of why they were not selected;

(6) A description of the controlled transactions (including the terms of sale) and any internal data used to analyze those transactions;

(7) A description of the comparables that were used, how comparability was evaluated, and what (if any) adjustments were made;

(8) An explanation of the economic analysis and projections relied upon in developing the method; and

(9) A general index of the principal and background documents and a description of the recordkeeping system used for cataloging and accessing those documents.

(C) BACKGROUND DOCUMENTS. The assumptions, conclusions, and positions contained in principal documents ordinarily will be based on, and supported by, additional background documents. Documents that support the principal documentation may include the documents listed in section 1.6038A-3(c) that are not otherwise described in paragraph (d)(2)(iii)(B) of this section. Every document listed in those regulations may not be relevant to pricing determinations under the taxpayer's specific facts and circumstances and, therefore, each of those documents need not be maintained in all circumstances. Moreover, other documents not listed in those regulations may be necessary to establish that the taxpayer's method was selected and applied in the way that provided the most accurate measure of an arm's length result under the principles of the best method rule in section 1.482-1T(b)(2)(iii). Background documents need not be provided to the Internal Revenue Service in response to a request for principal documents. If the Internal Revenue Service subsequently requests background documents, a taxpayer must provide that documentation to the Internal Revenue Service within 30 days of the request. However, the district director may, in his discretion, extend the period for producing the background documentation.

(3) APPLICATION OF AN UNSPECIFIED METHOD -- (i) IN GENERAL. An adjustment is excluded from the calculation of a net section 482 adjustment if the taxpayer establishes that both the unspecified method and documentation requirements of this paragraph (d)(3) are met with respect to that amount.

(ii) UNSPECIFIED METHOD REQUIREMENT -- (A) IN GENERAL. If a method other than a specified method was applied, the unspecified method requirement is met if the requirements of paragraph (d)(3)(ii)(B) or (C), as appropriate, are met.

(B) SPECIFIED METHOD POTENTIALLY APPLICABLE. If the transaction is of a type for which methods are specified in the regulations under section 482, then a taxpayer will be considered to have met the unspecified method requirement if the taxpayer reasonably concludes that, given the available data, none of the specified methods was likely to provide an accurate measure of an arm's length result, and that it selected and applied an unspecified method in a way that would likely provide an accurate measure of an arm's length result, given the available data. This conclusion must be based on all the facts and circumstances. The factors relevant to this conclusion include those set forth in paragraph (d)(2)(ii) of this section.

(C) NO SPECIFIED METHOD APPLICABLE. If the transaction is of a type for which no methods are specified in the regulations under section 482, then a taxpayer will be considered to have met the unspecified method requirement if it selected and applied an unspecified method in a reasonable manner. For purposes of this paragraph (d)(3)(ii)(C), a taxpayer's selection and application is reasonable if the taxpayer reasonably concludes that the method (and its application of that method) provided the most accurate measure of an arm's length result under the principles of the best method rule in section 1.482-1T(b)(2)(iii). This conclusion must be based on all the facts and circumstances. The factors relevant to this conclusion include those set forth in paragraph (d)(2)(ii) of this section.

(iii) DOCUMENTATION REQUIREMENT -- (A) IN GENERAL. The documentation requirement of this paragraph (d)(3) is met if the taxpayer maintains sufficient documentation to establish that the unspecified method requirement of paragraph (d)(3)(ii) of this section is met and provides that documentation to the Internal Revenue Service within 30 days of a request for it. That documentation must be in existence when the return is filed. The district director may, in his discretion, excuse a minor or inadvertent failure to provide required documents, but only if the taxpayer has made a good faith effort to comply, and the taxpayer promptly remedies the failure when it becomes known.

(B) PRINCIPAL AND BACKGROUND DOCUMENTS. See paragraphs (d)(2)(iii)(B) and (C) of this section for rules regarding these two categories of required documentation.

(4) CERTAIN FOREIGN TO FOREIGN TRANSACTIONS. For purposes of calculating a net section 482 adjustment, any increase in taxable income resulting from an allocation under section 482 that is attributable to any controlled transaction solely between foreign corporations will be excluded unless the treatment of that transaction affects the determination of either corporation's income from sources within the United States or taxable income effectively connected with the conduct of a trade or business within the United States.

(5) SPECIAL RULE. If the regular tax (as defined in section 55(c)) imposed on the taxpayer is determined by reference to an amount other than taxable income, that amount shall be treated as the taxable income of the taxpayer for purposes of section 6662(e)(3). Accordingly, for taxpayers whose regular tax is determined by reference to an amount other than taxable income, the increase in that amount resulting from section 482 allocations is the taxpayer's net section 482 adjustment.

(6) EXAMPLES. The principles of this paragraph (d) are illustrated by the following examples.

EXAMPLE 1. (i) The Internal Revenue Service makes the following section 482 adjustments for the taxable year:

 1) $ 9,000,000

EXAMPLE 2. (i) The Internal Revenue Service makes the following section 482 adjustments for the taxable year:

 1) $ 9,000,000

EXAMPLE 3. CFC1 and CFC2 are controlled foreign corporations within the meaning of section 957. Applying section 482, the IRS disallows a deduction for twenty five million dollars of the interest that CFC1 paid to CFC2, which results in CFC1's U.S. shareholder having a subpart F inclusion in excess of five million dollars. No other adjustments under section 482 are made with respect to the controlled taxpayers. However, the increase has no effect upon the determination of CFC1's or CFC2's income from sources within the United States or taxable income effectively connected with the conduct of a trade or business within the United States. Accordingly, there is no substantial valuation misstatement.

(e) SPECIAL RULES IN THE CASE OF CARRYBACKS AND CARRYOVERS. If there is a substantial or gross valuation misstatement for a taxable year that gives rise to a loss, deduction or credit that is carried to another taxable year, the transactional penalty and the net adjustment penalty will be imposed on any resulting underpayment of tax in that other taxable year. In determining whether there is a substantial or gross valuation misstatement for a taxable year, no amount carried from another taxable year shall be included. The following example illustrates the principle of this paragraph (e).

EXAMPLE. The Internal Revenue Service makes a section 482 adjustment of six million dollars in taxable year 1, no portion of which is excluded under paragraph (d) of this section. The taxpayer's income tax return for year 1 reported a loss of three million dollars, which was carried to taxpayer's year 2 year income tax return and used to reduce income taxes otherwise due with respect to year 2. A determination is made that the six million dollar allocation constitutes a substantial valuation misstatement, and a penalty is imposed on the underpayment of tax in year 1 attributable to the substantial valuation misstatement and on the underpayment of tax in year 2 attributable to the disallowance of the net operating loss in year 2. For purposes of determining whether there is a substantial or gross valuation misstatement for year 2, the three million dollar reduction of the net operating loss will not be added to any section 482 adjustments made with respect to year 2.

(f) RULES FOR COORDINATING BETWEEN THE TRANSACTIONAL PENALTY AND THE NET ADJUSTMENT PENALTY -- (1) COORDINATION OF A NET SECTION 482 ADJUSTMENT SUBJECT TO THE NET ADJUSTMENT PENALTY AND A GROSS VALUATION MISSTATEMENT SUBJECT TO THE TRANSACTIONAL PENALTY. In determining whether a net section 482 adjustment exceeds five million dollars or 10 percent of gross receipts, an adjustment attributable to a substantial or gross valuation misstatement that is subject to the transactional penalty will be taken into account. If the net section 482 adjustment exceeds five million dollars or ten percent of gross receipts, any portion of such amount that is attributable to a gross valuation misstatement will be subject to the transactional penalty at the forty percent rate, but will not also be subject to net adjustment penalty at a twenty percent rate. The remaining amount is subject to the net adjustment penalty at the twenty percent rate, even if such amount is less than the lesser of five million dollars or ten percent of gross receipts.

(2) COORDINATION OF NET SECTION 482 ADJUSTMENT SUBJECT TO THE NET ADJUSTMENT PENALTY AND SUBSTANTIAL VALUATION MISSTATEMENTS SUBJECT TO THE TRANSACTIONAL PENALTY. If the net section 482 adjustment exceeds twenty million dollars or 20 percent of gross receipts, the entire amount of the adjustment is subject to the net adjustment penalty at a forty percent rate. No portion of the adjustment is subject to the transactional penalty at a twenty percent rate.

(3) EXAMPLES. The following examples illustrate the principles of this paragraph (f).

EXAMPLE 1. (i) Applying section 482, the Internal Revenue Service makes the following adjustments for the taxable year:

 1) $ 2,000,000      (attributable to an adjustment that

EXAMPLE 2. The facts are the same as in EXAMPLE 1, except the taxpayer has gross receipts of 40 million dollars. The net section 482 adjustment ($4.5 million) is greater than the lesser of five million dollars or ten percent of gross receipts ($40 million x 10% = $4 million). Thus, the five million dollar or 10% of gross receipts test has been met. The two million dollar adjustment is attributable to a gross valuation misstatement. Accordingly, the taxpayer is subject to a penalty, under section 6662(h), equal to 40 percent of the underpayment of tax attributable to the gross valuation misstatement of two million dollars. The 2.5 million dollar adjustment is subject to a penalty under sections 6662(a) and 6662(b)(3), equal to 20 percent of the underpayment of tax attributable to the substantial valuation misstatement.

EXAMPLE 3. (i) Applying section 482, the Internal Revenue Service makes the following transfer pricing adjustments for the taxable year:

 1) $ 6,000,000      (attributable to an adjustment that is

(g) EFFECTIVE DATE. This section applies to taxable years beginning after December 31, 1993.

Par. 5. Section 1.6664-0 is amended by adding an entry for section 1.6664-4T to read as follows:

SECTION 1.6664-0 TABLE OF CONTENTS.

* * * * *

SECTION 1.6664-4T REASONABLE CAUSE AND GOOD FAITH EXCEPTION TO SECTION 6662 PENALTIES.

(a) through (c) (Reserved)

(d) Transactions between persons described in section 482 and net section 482 transfer price adjustments.

Par. 6. Section 1.6664-4T is added to read as follows:

SECTION 1.6664-4T REASONABLE CAUSE AND GOOD FAITH EXCEPTION TO SECTION 6662 PENALTIES.

(a) through (c) [Reserved]

(d) TRANSACTIONS BETWEEN PERSONS DESCRIBED IN SECTION 482 AND NET SECTION 482 TRANSFER PRICE ADJUSTMENTS. For purposes of applying the reasonable cause and good faith exception of section 6664(c) to net section 482 adjustments, the rules of section 1.6662-6T(d) of the regulations apply. A taxpayer that does not satisfy the rules of section 1.6662-6T(d) for a net section 482 adjustment cannot satisfy the reasonable cause and good faith exception under section 6664(c). The rules of this section apply to underpayments subject to the transactional penalty in section 1.6662-6T(b). If the standards of the net section 482 penalty exclusion provisions under section 1.6662-6T(d) are met with respect to such underpayments, then the taxpayer will be considered to have acted with reasonable cause and good faith for purposes of this section.

Par. 7. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 7. Section 602.101(c) is amended by adding an entry in numerical order to the table to read as follows:

SECTION 602.101 OMB CONTROL NUMBERS.

* * * * *

(c) * * *

 CFR part or section where identified              Current OMB