A recent disclosure by the Indiana Department of Revenue shows that a trend toward states engaging in transfer pricing in earnest is gaining traction. This shift requires a change in approach to defending intercompany transactions at the state level.
State revenue agencies have historically challenged intercompany transactions of multistate taxpayers through techniques unique to state taxation, including forced combination, alternative apportionment, related-party expense addback, and nexus assertion. As these tools have become less effective, state revenue agencies are training their auditors in traditional transfer pricing methodologies or outsourcing transfer pricing audits to third-party specialists.
Like their counterparts at the national and international levels, state revenue agencies closely examine intercompany transactions between related companies in an attempt to combat perceived tax avoidance. “Transfer pricing” refers generally to the income tax methodology for pricing related-party transactions that involve, for example, the sale of goods, provision of services, and licensing of intellectual property. In the United States, these rules are set out in Internal Revenue Code Section 482 and its related regulations.
At bottom, the aim of transfer pricing is to put transactions between related parties in tax parity with transactions between unrelated parties. In the state income tax context, transfer pricing issues have generally arisen in separate return states because intercompany transactions between related parties are eliminated in combined or consolidated reporting regimes. Recently, states are increasingly examining intercompany transactions with foreign affiliates as well, which are often excluded from state returns.
Historically, states have used a variety of methods to challenge intercompany transactions without addressing the economic pricing of such transactions, or directly testing a taxpayer’s transfer pricing analysis and support. These tools unique to state tax include the following:
Recently, taxpayers have successfully challenged states on the above arguments, in no small part because many of those arguments do not have a sound legal basis. Taxpayers also have found success where they challenged states’ lack of evidence to support claims that separate returns do not reflect a taxpayer’s income in the state or that transactions lack economic substance.
Further, taxpayers have found success when challenging a state’s attempt to ignore established transfer pricing rules and practice when applying the state’s codified version of Section 482. These recent wins have led to a trend by state revenue agencies to challenge intercompany transactions on the basis of federal transfer pricing principles. To that end, states have begun to invest heavily in transfer pricing resources by hiring experienced transfer pricing professionals to train was well as to join their audit teams.
With the recent setbacks in questionable enforcement tactics, states are taking on transfer pricing issues in a more direct manner. As early as 2016, the Multistate Tax Commission (MTC) has given significant attention to the issue, even creating a transfer pricing committee, the State Intercompany Transactions Advisory Service, to provide transfer pricing training to state auditors. While the MTC effort has not garnered widespread support, states have continued to push forward with measures to increase their transfer pricing audit capabilities.
Various state revenue agencies have hired outside firms to train auditors on analyzing transfer pricing studies. A study conducted by publisher Tax Analysts found at least 23 state revenue departments and the District of Columbia have contracted with outside transfer pricing experts, executed transfer pricing information exchanges between states, invested in dedicated transfer pricing teams, and/or sent personnel to Section 482 training.
For example, the Indiana Department of Revenue recently reported significant investment in a dedicated transfer pricing team. The state has hired third-party professionals to train its auditors and is creating an advanced pricing agreement program. Alabama, North Carolina, and Louisiana have contracted with transfer pricing consulting firm RoyaltyStat for training, audit support, and access to transfer pricing databases. The Massachusetts Department of Revenue has retained outside counsel and economic experts, including former US Treasury and IRS counsel personnel.
However, the use of outside experts has raised questions from industry professionals, specifically in the context of third-party firms working under contingency fee arrangements.
Taxpayers should expect revenue agencies to be even more aggressive in challenging intercompany transactions. Especially in a time when the coronavirus (COVID-19) pandemic continues to disrupt state revenue collection, states may be willing to use more creative approaches in audits and look to multinational taxpayers to make up deficits.
To prepare, taxpayers should ensure their transfer pricing studies are updated regularly and detail intercompany transactions appropriately. Taxpayers should be prepared to face state challenges that rely on transfer pricing principles rather than those that rely on the states’ historical tools and arguments.
Recent taxpayer wins have come based on accurate and up-to-date transfer pricing studies. Taxpayers can find success by enlisting a team of both state income tax and transfer pricing specialists. Morgan Lewis’s state tax and transfer pricing team will host a state transfer pricing webinar at the end of May to cover this topic in more depth.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Justin D. Cupples
Cosimo A. Zavaglia
Sanford W. Stark
 See E.I. Dupont de Nemours & Co. v. Indiana Dep’t of State Revenue, 79 N.E.3d 1016 (Ind. Tax Court 2017) (finding Indiana’s alternative sourcing statute did not allow the state to adjust the taxpayer’s income tax base but rather allowed the state to divide the taxpayer’s tax base in a different manner than the general sourcing statute; further, the court found the taxpayer’s transfer pricing study, which applied an arm’s-length standard to intercompany charges, was evidence that the taxpayer’s taxable income as reported on its return was fairly reflective of its income earned in the state).
 See Utah State Tax Comm’n v. See’s Candies, Inc., 435 P.3d 147 (Utah 2018) (affirming the district court’s finding that the taxpayer’s expert testimony demonstrated that its intercompany transactions met the arm’s-length standard codified in Utah Code § 59-7-113, and further, the state failed to present evidence to the contrary).
 See Amy Hamilton & Andrea Muse, “News Analysis: States Aggressively Contracting with Transfer Pricing Experts,” Tax Analysts (Apr. 6, 2020).
 For several years, taxpayers engaged in disputes with the District of Columbia’s Office of Tax Revenue over its use of transfer pricing analysis conducted by its subcontractor Chainbridge Software LLC, arguing that assessments were not based on the taxpayers’ books and records but on computer output.