US IRS will consider applying the economic substance doctrine and related penalties more frequently in transfer pricing audits

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EY Global

30 Nov 2022
Subject Tax Alert
Categories Transfer Pricing
Jurisdictions United States
  • The Acting Commissioner of the United States (US) Internal Revenue Service’s (IRS) Large Business and International Division stated that the IRS is "thinking about" asserting penalties under the economic substance doctrine.

  • Following a policy change, the IRS requires only approval from a supervisor, rather than executive approval, to assert economic substance and penalties related to economic substance.

  • Taxpayers might be able to avoid certain penalties by notifying the IRS of additional tax due under the process described in Revenue Procedure 2022-39.

According to a 16 November 2022 article in Tax Notes,1 Holly Paz, Acting Commissioner of the IRS's Large Business and International (LB&I) Division, told the American Bar Association Section of Taxation during its Philadelphia Tax Conference that the IRS will more frequently consider whether the economic substance doctrine applies in transfer pricing audits.

The economic substance doctrine, which is codified at Internal Revenue Code2 Section 7701(o), considers a transaction to have economic substance only if: (i) the transaction has a meaningful economic impact other than federal income tax effects; and (ii) 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 Section 6662(b)(6) or a 40% penalty under Section 6662(i). The IRS has said before that it is planning to assert penalties more frequently in transfer pricing cases (see EY Global Tax Alert, US IRS official reemphasizes IRS focus on penalties in transfer pricing cases, dated 23 September 2022).

Change in IRS policy

Paz's statement follows an April 2022 memorandum changing IRS policy to no longer require IRS executive approval before raising the economic substance doctrine in audits. When Section 7701(o) was first enacted, Paz said, executive approval was required because the IRS was unfamiliar with the doctrine. Under the new policy, revenue agents only need approval from their direct supervisor before asserting a penalty under the economic substance doctrine (which is similar to the process for other assessable penalties).

The memorandum also listed the circumstances under which applying the economic substance doctrine may be appropriate. Examples include: (i) a transaction being highly structured; (ii) a transaction including unnecessary steps; (iii) an artificial limitation on gain or loss; and (iv) a transaction generating a deduction that is not matched by an equivalent economic loss or expense.

Revenue Procedure 2022-39

Taxpayers should remember that the release of Revenue Procedure 2022-39 (pdf) on 16 November 2022, may allow them to avoid certain penalties by disclosing errors before an audit commences. Revenue Procedure 2022-39 (pdf), which replaces Revenue Procedure 94-69 (see Tax Alert 2022-1744), applies to taxpayers that: (i) have been selected for audit under the Large Corporate Compliance (LCC) Program or Large Partnership Compliance (LPC) Program; and (ii) have been audited four of the last five years under the LCC, LPC or the programs' predecessor or successors as of the date that the IRS first contacts them about the audit. Eligible taxpayers that notify the IRS of additional taxes due within 30 days of a request for such disclosure may avoid accuracy-related penalties under Section 6662(b)(1)-(2).


Given the Acting Commissioner's statement and the relaxation of the approvals needed for asserting penalties relating to economic substance, taxpayers should focus on penalty protection, particularly robust transfer pricing documentation, and consult with tax professionals before entering into transactions with related parties. Although Revenue Procedure 2022-39 provides a way for taxpayers to avoid certain penalties after filing a tax return, preemptive action is the best protection against owing additional taxes or paying penalties.


For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP (United States), National Tax Department, International Tax and Transaction Services, Transfer Pricing
  • Ryan J. Kelly, Americas ITTS Tax Controversy Leader, Washington, DC
  • Hiro Furuya, Dallas
  • Ameet Kapoor, San Jose
  • Carlos M. Mallo, Washington, DC
  • Marla McClure, Washington, DC
  • Donna McComber, Washington, DC
  • Mike McDonald, Washington, DC
  • Tom Ralph, Washington, DC
  • Kent Stackhouse, Austin
  • Thomas A. Vidano, Washington, DC
  • Heather Gorman, Washington, DC
  • Giulia Di Stefano, Washington, DC
  • Carolina Figueroa, Washington, DC
  • Mitch Gibson, Washington, DC

For a full listing of contacts and email addresses, please click on the Tax News Update: Global Edition (GTNU) version of this Alert.

  • Show article references#Hide article references

    1. Lauren Loricchio, IRS Eyeing Economic Substance Doctrine for Transfer Pricing, Tax Notes Today (16 November 2022).

    2. All “Section” references are to the Internal Revenue Code of 1986, and the regulations promulgated thereunder.