Many states are facing budgetary short-falls and seek new revenue sources to fill the gaps. States are increasing scrutiny of transfer pricing as a means to address budget shortfalls without publicly increasing taxes. As a result, transfer pricing compliance is no longer just an issue for multinational enterprises; rather, it is now a concern for all companies that transact across state borders with related party entities.
Transfer pricing is a pricing arrangement for a transaction between related legal entities. These inter-related party (intercompany) transactions may include the transfer of 1) tangible goods, 2) services, 3) intangibles and 4) intercompany loans. Historically, the focus was on pricing between related entities that operated in two or more countries (multinational). The US Internal Revenue Code section 482 requires that such intercompany transactions be conducted at “an arm’s length transfer price” (i.e., a price that is set as if the entities were independent companies and not related).
Historically, state tax authorities lacked the specific transfer pricing and economic expertise to perform transfer pricing analyses. Many state tax authorities were not able to combat income shifting across state lines. However, states are beginning to pool their resources in order to better address transfer pricing across state borders.
In July of 2014, the Connecticut Department of Revenue Services awarded Chainbridge Software LLC a contract to provide support for transfer pricing audits. Chainbridge Software LLC is well-known for assisting the District of Columbia Office of Tax and Revenue in assessing a $2.75 million adjustment against Microsoft (this case was tried and overturned on summary judgement).
The Massachusetts Department of Revenue has a reputation for being aggressive with intercompany payments between affiliated entities, having recently made transfer pricing or similar adjustments on intercompany transactions related to tangible goods, services, management fees, loans, and royalties. Massachusetts also litigated a number of transfer pricing matters in the courts.
Moreover, the Multistate Tax Commission (“MTC”) held training for state auditors in March 2015, entitled “Identifying Related Party Issues in Corporate Tax Audits,” in an effort to support states seeking to improve transfer pricing compliance. This training was part of the MTC’s ongoing training schedule to educate state auditors about transfer pricing.
Further, the MTC formed an advisory group, the Arm’s Length Adjustment Service (“ALAS”). The MTC Executive Committee approved a plan on May 7, 2015 for the ALAS program designed to enhance state level expertise. For states that participate, the program will 1) train state auditors, 2) establish information exchanges, 3) help states improve their tax administrative and compliance processes, 4) expand audit coverage for related party transactions, 5) provide assistance to states in developing and resolving transfer pricing cases, and 6) support states in defending their work in litigation. This program is designed to last a period of four years, with the initial implementation steps beginning in July 2015.
As a result of these efforts, enforcement of inter-state related party transactions will increase. Although state tax authorities will be able to better analyze taxpayer-provided transfer pricing studies, the number and magnitude of recommended adjustments will increase.
Transfer pricing issues are no longer reserved for companies with international operations; rather companies that transact across domestic state borders with related parties need to be prepared for increased enforcement from the states. Specifically, companies that have intercompany transactions that include 1) the licensing of intangible assets (such as patents and trademarks), 2) the purchase and resale of tangible goods, or 3) provide and charge for common services (such as legal, accounting, and payroll) should consider supporting documentation for its transfer pricing methodologies. Documentation should include an economic and financial analysis that supports the appropriateness and arm’s length nature of the calculations. The presence of robust supporting transfer pricing documentation will enable a company to defend itself against any transfer pricing adjustment proposed as a result of a state audit.
For more information on transfer pricing, contact Andrew Bostian at email@example.com or 617.658.5232.
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