Reporting for uncertain transfer pricing tax positions

New developments in transfer pricing have significantly altered the enforcement landscape and could change the way companies assess whether to reserve for transfer pricing issues as uncertain tax positions on their financial statements.

Accounting Standards Codification (ASC) 740, Income Taxes, controls how U.S. companies identify, measure, and report uncertain tax positions (UTPs) in their financial statements so that investors can make informed investment decisions. Transfer pricing is considered a tax “position” for this purpose and is one of the most common UTPs.

Many companies have historically reviewed their transfer pricing positions and concluded that they would ultimately win any transfer pricing dispute. Further, they concluded that the existence of IRC Section 6662 documentation would eliminate exposure to transfer pricing penalties. The combination of these taxpayer conclusions can result in low or no “unrecognized tax benefit.”

Recent IRS transfer pricing litigation success and a more aggressive approach to penalties could impact the measurement of transfer pricing positions under ASC 740. Further, an investor lawsuit over disclosure of a transfer pricing dispute and a non-tax case regarding deference to the government in regulation writing could impact the financial reporting of transfer pricing uncertain tax positions. In light of these developments, taxpayers should re-evaluate their measurement of UTPs.

Recognition and measurement

ASC 740 requires that all tax positions, including those for transfer pricing, be evaluated using a two-step process to determine if there should be any “unrecognized tax benefit.” In the first step, a tax position is only recognized if it is more likely than not to be sustained upon examination based on the technical merits. In the second step, the taxpayer must quantify how much of the tax benefit associated with the position is greater than 50% likely to be realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. The difference between the amount reported on the tax return and the measured amount is often referred to as the unrecognized tax benefit.

A number of detailed rules refine these measurement numbers:

• Both sides of the transaction must be considered with the assumption that both tax authorities have full knowledge of all relevant information when calculating any associated tax reserve. Detection risk is not a factor to be considered in determining whether a position is uncertain.
• Interest on the difference in the tax position that should have been taken and the amount actually reported or intended to be reported on the tax return must be included.
• Penalties imposed by the respective jurisdictions on the underpayment of tax must be included.
• If the taxpayer determines that a tax reserve is necessary, the computations should consider the likelihood and cost of pursuing litigation or a mutual agreement procedure.

Because relatively few transfer pricing disputes are resolved through litigation, measurement is often based on management's best judgment of the amount the taxpayer would ultimately accept in a settlement with taxing authorities. Given the IRS’s historically poor record in transfer pricing litigation, and its reluctance to assert penalties when documentation exists, companies willing to pursue tax litigation have often concluded that no or a low reserve was necessary. 

Recent transfer pricing enforcement decisions

But in recent years, the IRS has achieved at least a partial win in some major transfer pricing cases. A few examples include:

• Altera Corporation & Subsidiaries v. Commissioner, Nos. 16-70497 (Cir. 2019). On June 22, 2020, the U.S. Supreme Court declined to review the 9th Circuit decision in favor of the IRS regarding the inclusion of stock-based compensation in cost-sharing cost pools.
• The Coca-Cola Company & Subsidiaries v. Commissioner, 155 T.C. No. 10. On Aug. 2, 2024, the U.S. Tax Court entered a decision against The Coca-Cola Company that reflects a tax underpayment of approximately $2.7 billion for tax years 2007-2009. With applicable interest, the total underpayment is approximately $6 billion.
• 3M Company & Subsidiaries v. Commissioner, 160 T.C. No. 3. On Feb. 9, 2023, the U.S. Tax Court ruled in favor of the IRS in a case regarding when companies can take foreign legal restrictions into account under Treas. Reg. § 1.482-1(h)(2) (“blocked income”).
• Medtronic, Inc. and Consolidated Subsidiaries v. Commissioner, No. 17-1866. Upon receiving the case for a second time in a retrial, the Tax Court applied a three-step unspecified method that resulted in approximately $1.4 billion in adjustments for tax years 2005-2006.

Additionally, each of three recently filed Tax Court transfer pricing cases include the IRS assertion of penalties:

• Amgen Inc. et al. v. Commissioner, T.C., No. 16017-21, 4/4/24.  The IRS alleges an underpayment of $10.7 billion of tax and penalties.
• Newell Brands, Inc. v. Commissioner, T.C., No. 11897-24, 7/19/24. The IRS alleges an underpayment $90M of tax and $34M in related penalties.
• Airbnb Inc. v. Commissioner, T.C., No. 12423-24, 7/31/24. The IRS alleges an underpayment of taxes by $1.33 billion for 2013, plus $573 million in penalties.

In one case not yet filed, Microsoft is engaged in a transfer pricing dispute with the IRS over $28.9 billion of additional taxes, plus penalties and interest for tax years from 2004 through 2013.

The recent trend of IRS success in transfer pricing litigation makes it more difficult to conclude that the taxpayer will ultimately win its transfer pricing dispute with the IRS. The recent change in the IRS approach regarding assertion of transfer pricing penalties should also be reflected in UTP measurement computations.

Non-tax litigation that could impact UTP

In 2023, the Roofers Local No. 149 Pension Fund (plaintiff) sued Amgen Inc. and others based on Amgen’s alleged failure to adequately disclose information about transfer pricing disputes with the IRS regarding the allocation of profits between Amgen affiliates in the U.S. and Puerto Rico. According to the plaintiff, Amgen did not share specific information in its possession about the IRS proposed adjustment before the July 29, 2020, filing of its quarterly report on Form 10-Q. Amgen disclosed the transfer pricing dispute with the IRS regarding the Puerto Rico transactions and took the position that the IRS positions were “without merit,” but omitted the fact that the amount at issue was over $10.7 billion in total.

In 2024, the Supreme Court overturned the decades-long Chevron deference to agency rule-making in Loper Bright Enterprises v. Raimondo, U.S., No. 22-451. The decision could lead to new regulatory challenges and changes to the administration of transfer pricing and other income tax issues. Chevron deference was a legal precedent set in the 1984 Supreme Court case, Chevron v. Natural Resources Defense Council (467 U.S. 837), which essentially deferred to an agency’s interpretation of any ambiguous statute as long as the interpretation was reasonable and not arbitrary and capricious.

With Chevron invalidated, it is not completely clear what standard courts will apply to determine the validity of regulations. The Loper Bright decision references the standard set by the Supreme Court in 1944 in Skidmore v. Swift & Co. (323 U.S. 134), which generally defers to a regulation based on its persuasiveness, including the thoroughness of its analysis, the validity of its reasoning, and the consistency of interpretation with other agency interpretations. For tax regulations, there is some additional question of whether the end of Chevron will resurrect another standard set in 1979 in National Muffler Dealers Assn., Inc. v. United States (440 U.S. 472), which created a distinction between interpretive regulations based on the IRS’s general authority and legislative regulations based on an explicit grant of authority for a specific statutory provision.

This could be particularly important for transfer pricing because the rules contained in Section 482 are general and brief, and the practical application of transfer pricing relies almost entirely on more expansive rules created by IRS regulations. Section 482 gives the Treasury Secretary explicit authority to enforce transfer pricing rules, but this grant of authority does not specifically mention regulations, and there will likely be increasing challenges to IRS transfer pricing regulations.