On December 13, 2024, Robert Kelley, chief of Branch 6 of the IRS Office of Associate Chief Counsel (International), said at a conference that the IRS can apply the economic substance doctrine to transfer pricing cases.1

Speaking at the George Washington University's Annual Institute on Current Issues in International Taxation conference, Kelley said "[s]ome taxpayers have made the argument that if you're in the related party context and you can use [IRC Section] 482 that you're therefore insulated from the economic substance doctrine. And we disagree with that."2

The economic substance doctrine, which is codified at IRC Section 7701(o), considers a transaction to have economic substance only if (1) the transaction has a meaningful economic impact other than federal income tax effects, and (2) the taxpayer has a substantial purpose for entering the transaction other than for federal income tax purposes. If a transfer pricing 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).

Kelley's statements are consistent with past IRS statements on the use of the economic substance doctrine. In November 2022, Holly Paz, Acting Commissioner of the IRS's Large Business and International (LB&I) Division, said during a conference that the IRS will more frequently consider whether the economic substance doctrine applies in transfer pricing audits after an April 2022 memorandum changing IRS policy to no longer require IRS executive approval before raising the doctrine in audits (see Tax Alert 2022-1777). In January 2023, however, Robin Greenhouse, the Large Business and International (LB&I) Division Counsel, stated at a meeting that examiners still must consult with IRS counsel before asserting penalties related to the economic substance doctrine (see Tax Alert 2023-0161).

Implications

The IRS's public confirmation that the economic substance doctrine applies to transfer pricing underscores the need for taxpayers to make sure their intercompany transactions have a substantial business purpose beyond tax benefits. To reduce the chance of penalties under IRC Section 6662, companies should check that their transfer pricing documentation addresses both the arm's-length standard and the economic substance requirements.