This scrutiny and litigation continues to be a trending topic, increasing in transparency and crackdown by tax authorities on a global level. The past few weeks we have seen an uptick in discussions pertaining to coordinated enforcement on the purely domestic front in the United States. State-level auditors are going on record with organized efforts to identify and audit the intercompany transactions of corporations operating within their states to ensure arm’s length – or market-rate – pricing with affiliated firms.
The perception is that corporations are dealing in tax rate arbitrage on the state level, not just the international one, seeking to minimize taxes paid in high taxed states by allocating more income to low taxed states via transfer pricing manipulation. State tax authorities are seeking to protect tax base erosion, or more accurately, increase sources of tax revenue via income adjustments around intercompany pricing. The general state of the world economy today is prompting outside the box thinking on new areas of revenue-generation, and government agencies are not immune to this trend.
This trend for transfer pricing scrutiny applies to the separate reporting states, and generally not applicable to states with mandatory group filing (e.g. combined reporting states). While many states have moved to a combined reporting structure, where one tax return is filed for the parent and affiliates regardless of location, there are number of states that employ separate reporting regimes; meaning separate tax returns are required for each affiliate that has nexus.
Thus far, this has been more of a vague concept on the state level, with broad and ambiguous authority prescribed to state tax auditors to make transfer pricing income adjustments. State provisions tend to garner considerable attention on intercompany transactions pertaining to management fees, debt (i.e. interest expense), and intellectual property (i.e. royalties). Outside of this realm, it is often considered to be abstruse in how states regulate against profit shifting, as states sometimes find themselves with limited tools in addressing. The states often hold the ability to assert discretionary authority to adjust businesses profits. Further, states may combat these so called “abuses” by asserting nexus with the out-of-state related entity and/or force combination through audits.
In many cases there has been very limited case law for auditors and taxpayer’s to seek guidance. In three more recent state tax cases involving transfer pricing adjustments, the courts all sided with the taxpayer. The courts agreed the state tax agencies misused their discretionary authorities to reallocate the taxpayer’s income. The state could not present defensible support for income adjustments related to transfer pricing.
However, just this month there is more explicit discussion of Treas. Reg. §1.482 of the Internal Revenue Code (“Treas. Reg. §1.482”) applying to the state taxation. Under Treas. Reg. §1.482, transfer prices within a controlled group must meet the arm’s-length standard and, thus, be consistent with the results that would have been realized if uncontrolled taxpayers had engaged in similar transactions under similar circumstances. In short, affiliated companies must operate as if independent, total strangers, using market-rate pricing. Note that a negotiation between two affiliated firms does not result in market-rate pricing. Rather, the pricing must be benchmarked to comparable firms or transactions in the marketplace via an economic analysis based on Treas. Reg. §1.482 methodologies.
Several states, mostly in the Southeast, are taking a more united, proactive, and aggressive approach to educating themselves on scrutinizing taxpayer’s transfer pricing. They meet regularly and are advised by transfer pricing consultants, training state audit teams on how to target taxpayers, assess transfer pricing, and build an economically-sound argument that pricing is not market-rate and an income adjustment may be warranted. Multistate businesses with separate state tax filings should consult with their transfer pricing and state tax advisors for guidance on how to assess and mitigate audit risk.
Two states are a bit further along, with Indiana and North Carolina offering options for businesses operating in those states to address and negotiate transfer pricing. North Carolina has launched a voluntary disclosure program, focused on resolving transfer pricing in back years. Businesses operating in North Carolina can voluntarily step forward to disclose and adjust any prior years transfer pricing, paying the additional taxes without penalty. There is a very brief window for taking advantage of this program, with disclosure deadlines in September and October, so corporations should consult their transfer pricing and state tax advisors to assist in engaging in these interactions and negotiations with state tax authorities.
Indiana has adopted a state-level Advance Pricing Agreement (“APA”) program where taxpayers can voluntarily opt to work with the government to prospectively negotiate transfer pricing. Resolution in an APA setting allows taxpayers a high degree of certainty that their transfer pricing will not be disputed and there will be no need for costly and time-consuming future litigation. Best candidates for pursuing an APA are companies with higher levels of intercompany transfers, or with a contentious audit history with the state. The commitment is heavy, so the APA approach is not for the casual Indiana taxpayer.
The COVID-19 crisis amplifies this, where states will be looking for revenue and this is an area that could see increased scrutiny as well as allocation of wages due to tele-commuting. While the connection between state tax and transfer pricing is relatively new in the press, there has been a behind-the-scenes movement for a few years. Withum, and presumably other advisors, have been working with their clients to address purely domestic intercompany pricing.
It’s critical to reach out to your advisors today so you understand your company’s position and tax exposure in this area. Withum can assist you in mitigating this risk. Applying arm’s length – or market-rate – pricing to transactions between affiliated entities has many advantages. Here are 4 ways that Withum can help put your organization in a position of strength: