January 27, 2023
IRS examiners must consult IRS counsel before applying the economic substance doctrine in transfer pricing audits
On January 18, 2023, Robin Greenhouse, the Large Business and International (LB&I) Division Counsel, stated at a meeting of the American Bar Association Section of Taxation that examiners still must consult with IRS counsel before asserting related penalties related to the economic substance doctrine (ESD).1 The statement follows an IRS decision to no longer require IRS examiners to obtain executive-level approval in order to assert the ESD under IRC Section 7701(o) during an audit (see Tax Alert 2022-1777).
The ESD assesses whether (1) a transaction impacts a taxpayer's economic position beyond the federal income tax effects, and (2) the taxpayer had a substantial business purpose for entering into the transaction other than for federal income tax purposes. If a transfer pricing position lacks economic substance, the IRS, in addition to proposing audit adjustments, may assert IRC Section 6662(i) penalties of up to 40%.
After the April guidance, examiners no longer have to obtain executive-level review. Instead, according to a Tax Notes Today article, Greenhouse said at the meeting that "[i]nitial review and coordination of the potential assertion of the doctrine begins with field counsel advising examiners." The review "extends up the chain of command through … herself and is coordinated with the associate chief counsel for procedure and administration and briefed to the deputy chief counsel of operations," Greenhouse added. "Matters undergo 'a very thorough analysis by counsel as to whether or not we think that this is an appropriate instance in which codified economic substance should be applied,'" Greenhouse also said, according to the article.
LB&I plans to hire more than 160 attorneys between fiscal year 2022 and 2023 to help conduct these reviews.2 If appropriately utilized, these increased resources could limit the extent to which an ESD penalty review increases the duration of an audit.
Greenhouse's statement is the latest clarifying the IRS's policy on transfer pricing audits after another IRS official stated that the IRS will assert penalties more frequently in transfer pricing audits (see Tax Alert 2022-1426). Taxpayers should consider the ESD when planning their intercompany transactions and create contemporaneous supporting documentation. Taxpayers should also continue to focus on penalty protection measures, including transfer pricing documentation and consulting with tax professionals, as the IRS provides greater clarity on its approach to penalty application. Preemptive action is the best protection against paying penalties.
Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor
1 Chandra Wallace, IRS Counsel is Keeping Up Economic Substance Review, Tax Notes Today (January 19, 2023).