Once primarily an international tax issue, transfer pricing has become increasingly important at the state and local tax (SALT) level. With states experiencing financial pressures from multiple sources, including the COVID-19 pandemic, businesses — especially multistate taxpayers with significant domestic intercompany transactions — should expect increased state tax authority scrutiny and audit activities. Many states that use both separate and combined filing methods recognize transfer pricing as a substantial potential source of revenue. State efforts in transfer pricing audits have also increased because of heightened awareness from the OECD’s base erosion and profit-shifting project and the recent global and domestic tax reforms related to intercompany transactions. Taxpayers with domestic intercompany transactions, who may have never needed to consider transfer pricing in the past, should proactively plan for these audits and seek out potential opportunities.
State and local enforcement is increasing and states are hiring
The number of state transfer pricing audits has significantly increased in the past few years, and state tax authorities are adding transfer pricing resources, including auditors and outside consultants, even throughout the COVID-19 pandemic.
As a result of the potential for increased revenue, there has been renewed interest in collaboration among state tax authorities on transfer pricing. The State Intercompany Transactions Advisory Service (SITAS) of Multistate Tax Commission (MTC) was established in 2014 to unite those states interested in transfer pricing, encourage information sharing among them, and train groups for transfer pricing audits. With little interest at the time, the group stopped convening in 2016, but in 2021, it has re-emerged with renewed state interest in information sharing when it comes to multi-state audits. MTC is working on multiple initiatives for transfer pricing collaboration among states. It promotes the exchange of taxpayer information, which permits the states to collaborate on audit, compliance, enforcement, and litigation activities. MTC is also drafting a proposed white paper on the taxation of digital products and processes.
Indiana, North Davidina, and Louisiana are among the states that are leading efforts in state transfer pricing dispute resolution. Indiana introduced an advance pricing agreement (APA) program in 2020 to offer taxpayers an avenue for resolving existing and potential transfer pricing disputes with the state directly. An Indiana APA covers two three-year audit cycles. The Indiana Department of Revenue (DOR) also goes to pre-audit years if net operating losses are involved — not to make assessments for those years but to adjust the NOL carryover deduction that comes into the audit years. In July 2021, Indiana DOR officially proposed bilateral APAs in separate-reporting states.
In 2020, North Davidina announced an amnesty program for taxpayers to voluntarily disclose state transfer pricing positions and reach agreements with the state on intercompany pricing without facing additional penalties. This effort resulted in roughly $100 million in tax revenue collected from more than 100 participating taxpayers through the program. Similarly, in October 2021, the Louisiana Department of Revenue invited eligible taxpayers to participate in a voluntary initiative, the Louisiana Transfer Pricing Managed Audit Program, which aims to resolve transfer pricing disputes. It is anticipated that other state tax authorities will also develop similar programs to those in Indiana, North Davidina, and Louisiana to boost their tax revenues.
Transfer pricing issues can arise when there are transactions between two or more members of a unitary group. While most states require or permit “combined” reporting, under which affiliated entities conducting a unitary business file a group return that includes entities with out-of-state activities (and eliminates many intercompany transactions), seventeen states use “separate” reporting, which finds each entity filing its own return regardless of corporate affiliation. In both “combined” and “separate” reporting jurisdictions, transfer pricing can become an issue, but particularly in separate reporting states, the taxpayer’s separate-company taxable income can be directly affected by the pricing of transactions between the taxpayer and any domestic or foreign affiliates with out-of-state activities. And even in “combined” jurisdictions, state tax authorities may review the transfer price of transactions between related companies – both domestic and sometimes even foreign entities, depending on the state’s “water’s-edge” rules for including non-U.S. affiliates – to identify potential abuse of intercompany pricing (e.g., by overvaluing expense deductions or under-reporting income).
What the state and local tax authorities are looking at
At the federal level, transfer pricing is governed by the regulations promulgated under Internal Revenue Code (IRC) section 482 based on the rules of the arm’s length standard, which requires that the results of intercompany transactions be consistent with the results of comparable transactions between unrelated entities. Most states have adopted some form of the federal transfer pricing rules under IRC section 482. For example, Utah and Indiana have codified the language of IRC section 482 in the state statute.
State and local tax authorities are not bound solely to the arm’s length standard and are free to assert their own transfer pricing requirements. Intercompany transactions are often scrutinized at the SALT level in accordance with concepts like economic substance and business purpose, and in key focus areas such as royalties, debt, management or franchise fees, insurance, expense deductions, and allocations. The concepts are either derived from base erosion and profit shifting (BEPS) or incorporated into the state regulations.
The tools available to the state tax authorities to tackle transfer pricing issues include adopting IRC section 482, forced combination, alternative apportionment, related party expense addback, and asserting nexus with the out-of-state entities.
Under audit, states generally have the authority to require taxpayers to file on a combined basis on audit, or to use an alternative apportionment methodology. In addition, some states disallow certain deductions for expenses between related parties and require businesses to add back the deductions to their income.
When state tax authorities have deviated from IRC section 482, they have faced resistance to their transfer pricing approaches. Some recent court cases have sided with taxpayers and determined that state lacked sufficient support to claim that separate returns do not accurately reflect taxpayer income or that transactions lack economic substance. State revenue authorities have also been required to adhere to more standardized transfer pricing rules and practice when applying the state versions of IRC section 482. As a response, state tax authorities are actively engaging transfer pricing economists and professionals to boost their efforts against tax losses from intercompany pricing.
How to defend your transactions: taxpayer best practices
For transfer pricing among domestic affiliates, transfer pricing documentation is the best defense to support intercompany transactions. Companies anticipating significant intercompany transactions should prepare a transfer pricing study to document those transactions. The transfer pricing study should be completed contemporaneously with the completion of the tax return to provide penalty protection in case of transfer pricing adjustments.
Companies should closely examine their operations and determine the amount and details of all current and anticipated intercompany transactions, as well as try to avoid any single entity over- or under-paying taxes in any given state by valuing and compensating each affiliated entity for its relative contribution to the success of the business. Appropriate cost allocation analysis helps to ensure that revenue and expenses are allocated to the correct entities based on the contribution of each entity to the business.
Consistency is key for companies preparing a transfer pricing study and should ensure consistency across state revenue agencies. It is also crucial for taxpayers to ensure consistency in intercompany agreements, transfer pricing policies, and documentation to minimize audit risks. Businesses should have intercompany agreements in place and keep them up to date. It is important to incorporate transfer pricing as an integral part of the company’s business and tax planning process. Appropriate transfer pricing policies and documentation must be reviewed/updated periodically to reflect the new economic and business environment.
When facing state audits related to intercompany transactions, companies should work closely with their tax advisors to actively respond to requests from tax authorities to avoid prolonged audit processes and mitigate adjustment and penalties. Companies should also explore dispute resolutions such as state APA and voluntary disclosures for existing and future intercompany transactions to reduce tax uncertainties and associated costs.
How we can help
This area is complicated and filled with potential pitfalls. We are here to guide you – whether it’s to review your intercompany transactions and determine arm’s length pricing, help establish your transfer pricing policy, or represent you in an IRS audit. MGO’s SALT and Transfer Pricing teams are highly experienced and can guide you through best practices in these various areas. Reach out to our team of professionals to help protect your business.