Posted by: Steven Toscher | April 7, 2020

State Tax Agencies Preparing for Increased Transfer Pricing Enforcement by Steven Toscher, Lacey Strachan and Tenzing Tunden

Transfer pricing tax disputes are the highest dollar for dollar cases that are before the U.S Tax Court currently, with cases that involve cross-border transactions of large multinational corporations. These are particularly important tax matters for states where multinational corporations are headquartered and/or conduct business.  But transfer pricing controversies are not limited to large multinationals—the transfer pricing rules apply to every company engaged in cross-border transactions with related parties.  Transfer pricing issues will sometimes even be raised in domestic transactions involving related parties, where the related parties have different tax situations.

Transfer pricing has now gotten the attention of states.  States have been hiring outside experts and consultants, many of whom are former senior government officials, for transfer pricing expertise to assist the tax agencies in transfer pricing examinations of intercompany transactions.

What is Transfer Pricing

Transfer pricing refers generally to the setting of prices for property and service sold between controlled entities, such as a parent corporation selling goods to a subsidiary. These intercompany transactions often occur between “high tax” jurisdictions and “low tax” jurisdictions, such as Ireland and Luxembourg.[i]

IRC §482 and the regulations thereunder[ii] govern the pricing between these entities. IRC §482 is designed to prevent income shifting through controlled transactions, by allowing the IRS to adjust the amount charged in related-party transactions for purpose of determining a related party’s taxable income, if the amount charged is determined to not be “arm’s length.” Under §482’s transfer pricing rules, the IRS has the power to distribute, apportion, or allocate gross income, deductions, credits or allowances between or among related parties if it determined that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or to clearly reflect their income.

If the IRS makes an adjustment, the adjustment may be subject to a substantial or gross valuation misstatement penalty.[iii] Areas covered by IRC §482 and the Treasury Regulations include: loans, use of tangible property, sale of tangible property, transfer and use of intangible property, services, and cost-sharing arrangements. Under IRC §482, controlled entities should price transactions in the same way that uncontrolled entities would under similar circumstances.  Obtaining a transfer pricing study when setting prices will help taxpayers be prepared for an audit and potentially avoid penalties.[iv]

State Tax Implications

Numerous states have a statutory provision that either conforms or substantially conforms to IRC §482.  While some states still retain a separate reporting regime for taxpayers, a majority of states have combined reporting (such as a water’s edge combined reporting). This filing method requires affiliated domestic companies that are engaged in a unitary business to report their total income—regardless of where earned—as though the group were a single unified business.

Some states, such as Connecticut and Washington D.C., also require taxpayers to include in their water’s edge reporting affiliates that are doing business in overseas “tax havens,” regardless of the amount of U.S. activity they have conducted.[v] If there are transactions between entities that are within and without the water’s edge group, then there exists the potential for intercompany transfer pricing issues. While the IRS’s focus is mostly on cross-border transactions, states are also focused on ensuring that income is clearly reflected for domestic related companies, where a company may want to take advantage of another state’s more favorable regime.

Cooperation Amongst State Tax Agencies

The Multistate Tax Commission (MTC) is an intergovernmental state tax agency with the mission of promoting uniform and consistent tax policy and administration among the states.[vi] The MTC developed a plan in 2015 to help states jointly address intercompany transactions.[vii]  This led to the creation of the MTC’s “Arm’s Length Adjustment Service Committee” the following year.  The MTC’s goal was to create a program of services for participating states, including the ability to combine their resources to make more efficient use of top transfer-pricing experts.  Although the program did not come to fruition since few states participated in the program, this kickstarted an effort by numerous states to cooperate together in transfer pricing audit issues.

The MTC’s most recent two-day training on transfer pricing took place in March 2019 and was attended by revenue staff from 16 states, including staff from the following eight new participating jurisdictions: Arkansas, Delaware, Kansas, Missouri, Oregon, Utah, West Virginia and Wisconsin.

In the past five years, consulting firms have most frequently been retained by state tax departments to train their staff. The contracts have been for services ranging from training on transfer pricing methods to assistance in selecting taxpayers for audit, preparation of economic reports that support a state’s adjustments, and serving as expert witnesses during litigation.

We expect to see increased audit activity by states into intercompany transacting pricing matters, as state agencies become better trained on transfer pricing matters and have greater resources through cooperation of other states to hire transfer pricing experts.

Steven Toscher is a Principal at Hochman Salkin Toscher & Perez P.C., and specializes in civil and criminal tax litigation. Mr. Toscher is a Certified Tax Specialist in Taxation, the State Bar of California Board of Legal Specialization and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation.

Lacey Strachan is a Principal at Hochman Salkin Toscher Perez P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury).  Ms. Strachan has experience in a wide range of civil and criminal tax cases, including cases involving technical valuation issues, issues of first impression, and sensitive examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise. 

Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C. Mr. Tunden recently graduated from the Graduate Tax Program at NYU School of Law and the J.D. Program at UC Davis School of Law. During law school, Mr. Tunden served as an intern at the Franchise Tax Board Legal Division and at the Tax Division of the U.S. Attorney’s Office (N.D. Cal).

 

[i] See Veritas Software Corp. et al. v. Comm’r, 133 T.C. 297 (2009) and Amazon v. Comm’r, 148 T.C. No. 8 (2017).

[ii] Treas. Reg. §1.482-0 through §1.482-9.

[iii] IRC §6662(e)(1)(B)(i) 40% gross valuation misstatement if the price is 400% or more or 25% or less. Also see IRC §6662(h)(2)(A)(ii)(1).

[iv] See ”IRS Increases Focus on Transactions Between Commonly Controlled Entities in the Mid-Market Segment,” by Lacey Strachan, TAXLITIGATOR – Tax Controversy (Civil & Criminal Report) (June 8, 2017), https://taxlitigator.me/2017/06/08/irs-increases-focus-on-transactions-between-commonly-controlled-entities-in-the-mid-market-segment-by-lacey-strachan-2/.

[v] See D.C. Code Sections 47-1805.02a(a)-(b);-1810.07(a)-(c). Also see Conn. Gen. Stat. sections 12-213(a)(29) and 222(g)(1).

[vi] Multistate Tax Commission, http://www.mtc.gov.

[vii] MTC History, http://www.mtc.gov/The-Commission/MTC-History.


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