IRS Increases Application of the Economic Substance Doctrine: How to Mitigate Penalties and Have a Smoother Transfer Pricing Audit

The majority of corporate transactions typically reflect at least two separate elements. One is the business arrangement agreed to by the parties involved, and the other is the tax planning designed to minimize taxes while allowing the business arrangement to be fulfilled. In order to strike the appropriate balance, the potential impact of the “economic substance doctrine” is essential.

Over the years, some degree of uncertainty arose through different applications of the economic substance doctrine by various courts. This led to the codification of the economic substance doctrine in 2010 by IRC Section 7701(o). The doctrine considers a transaction to have economic substance only if:

  • The transaction has a meaningful economic impact other than federal income tax effects; and
  • The taxpayer has a substantial purpose for entering the transaction other than for federal income tax purposes.

The doctrine constitutes a major tool for the IRS to counter tax abusive transactions because a transaction that has no economic substance will not be respected for income tax purposes in the United States. Additionally, if a related party transaction fails to have economic substance, the IRS may assert a 20% penalty under IRC Section 6662(b)(6) or a 40% penalty under IRC Section 6662(i).

Recently, the Acting Commissioner of the IRS’s Large Business and International Division, Holly Paz, stated that the IRS plans to consider the application of the economic substance doctrine in transfer pricing audits more frequently going forward. She further stated that this move will inherently lead to an increased focus on “sham” transactions while asserting more penalties in transfer pricing cases.

The Acting Commissioner’s comments follow the April 2022 Memorandum, which changed the IRS policy to no longer requiring IRS executive approval before raising the economic substance doctrine in audits. Under the new policy, IRS agents only need approval from their direct supervisor before asserting a penalty under the economic substance doctrine.

While the authority to apply a 20% or 40% penalty on transfer pricing adjustments is not new, the ease of doing so is. It was previously a lengthy approval process involving a lot of paperwork, providing a disincentive for IRS agents to consistently apply penalties to income adjustments. This new and streamlined process will make it easier, and thus more likely, for revenue agents to apply transfer pricing penalties.

The memorandum also listed the circumstances under which applying the economic substance doctrine may be considered appropriate. Examples include:

  • A transaction being highly structured;
  • A transaction including unnecessary steps;
  • An artificial limitation on gain or loss; and
  • A transaction generating a deduction that is not matched by an equivalent economic loss or expense.

While the IRS anticipates an increase in the assertion of penalties in transfer pricing matters, the recently passed Inflation Reduction Act (IRA) will give them the necessary funding to implement those actions. The IRA included $79.6 billion in additional funding for the IRS over the next ten years, $45.6 billion of which was set aside for enforcement-related activities. Additionally, in the last few years, the IRS has been looking to hire more transfer pricing economists to gain the required expertise and grow in that field. For more information, see the following article: Inflation Reduction Act Funding to IRS Will Increase Examinations; Time to Focus On Transfer Pricing.

Given these recent developments, here are the key takeaways for taxpayers to mitigate possible transfer pricingrisks related to income adjustments or penalties:

  • Prepare and maintain robust annual transfer pricing documentation in compliance with IRC Section 482 and OECD Guidelines for most non-US markets;
  • Ensure there areoperational business reasons for all intercompany transactions and not purely tax-motivated reasons; and
  • Build economic substance by ensuring that the three main aspects supporting a company's transfer pricing are aligned: transfer pricing documentation study, intercompany accounting, and intercompany legal agreements.

If you want to ensure your company’s intercompany arrangements are tax-compliant, Withum’s dedicated transfer pricing professionals would be happy to assist you. Withum can create critical transfer pricing documentation to support the economic substance of the transactions and ensure the results are consistent with the arm’s length standard of worldwide tax regulations.

Authors: Marina Gentile, Partner and Lead, Global Transfer Pricing Strategies | [email protected] and Mukul Chhabra | [email protected]

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For more information on this topic, please contact a member of Withum’s Transfer Pricing Services Team.