Intercompany Transactions Remain Front and Center for State Tax Developments

The Bloomberg BNA Tax Management Weekly State Tax Report filters through current state developments and analyzes those critical to multistate tax planning.

By Richard W. Genetelli and David B. Zigman

Richard W. Genetelli, CPA, is the founder of the state and local tax consulting firm of The Genetelli Consulting Group, New York, N.Y. Previously, he was a partner for 10 years in the New York City office of Coopers & Lybrand (now PwC), having served as the national and regional leader of the state and local tax practice. David B. Zigman, J.D., is a manager with The Genetelli Consulting Group and a member of the New York State Bar Association. The authors can be reached at and


Intercompany transactions are commonly utilized as a vehicle to implement state tax planning strategies. Accordingly, such transactions garner considerable scrutiny by the states. The states focus on intercompany transactions in a number of ways. For example, some states rely on combined or consolidated (hereinafter referred to collectively as combined) reporting, which effectively treats affiliated companies as a single entity, thereby avoiding the need for a review of intercompany transactions. Other states pass legislation to negate the impact of intercompany transactions. Still another way states focus on intercompany transactions is by conducting §482-type audits. And a number of states attempt to tax companies that lack physical presence in the state, but which direct activities (generally through affiliated entities) at the state's economic forum (thus creating economic nexus and/or affiliate nexus according to the states). A survey of recent developments illustrates the attention the states are giving to intercompany transactions.

Background: Intercompany Transactions

Before turning to recent events, a little background on intercompany transactions is in order. Transactions among affiliated entities may be negotiated at prices that do not reflect fair market value. Such pricing may occur because free market conditions are absent when related entities transact business. As a result, items of income and expense may shift between related members.

At the federal level, the shifting of income and expenses among affiliated group members may cause income to escape U.S. taxation. The provisions for consolidated income tax returns1 can negate many transfer pricing issues among affiliated entities at the federal level because certain intercompany transactions are generally eliminated in the computation of federal consolidated taxable income.2 When intercompany pricing issues are not resolved by a consolidated income tax filing, the I.R.S. has another means of adjusting income and expenses. I.R.C. §482 permits the I.R.S. to redistribute, reallocate or reapportion certain items of gross income, deductions, credits or allowances among affiliated group members in order to prevent the evasion of taxes or to more clearly reflect the income of any group member.

I.R.C. §482 attempts to place controlled taxpayers on an equal footing with uncontrolled taxpayers by adopting an arm's-length standard for pricing intercompany transactions. The arm's-length standard requires affiliated entities to set transfer prices at the amount at which the transactions would have occurred between unrelated parties. By utilizing I.R.C. §482, the I.R.S. is able to adjust transactions between affiliated entities to reflect negotiations under free market conditions.

At the state level, the shifting of income and expenses among affiliated group members presents additional issues not relevant for federal purposes. Income may shift from one state to another, reducing the affiliated group's overall state tax liability if such income shifts to a state with a lower tax rate. This may occur when income shifts from a taxpayer in a given state to a nontaxpayer in that state that conducts all of its business activities in a lower income tax state. This may also occur when income shifts to a taxpayer with a lower apportionment percentage in a given state that conducts the remainder of its activities in a lower income tax state. In certain instances, even when state tax rates are equivalent, income shifting may produce a reduction in the affiliated group's overall state tax liability in light of combined and separate reporting implications. At the state level, transfer pricing may also facilitate the utilization of net operating losses and tax credits.

Forced Combination

One method used by the states to eliminate the effect of intercompany transactions is to require an affiliated group of companies engaged in a unitary business to file on a combined basis. Generally, under state combined reporting provisions, the members of an affiliated group compute their state tax base and apportionment factors as if the companies were a single entity. Pursuant to such a filing, intercompany transactions are generally eliminated. While the states apply a number of different approaches to determine the existence of a unitary business, unity is generally presumed to exist if there is a high degree of interrelationship and interdependence among the activities of the related companies.

An affiliated group of companies can, of course, challenge a state's attempt to impose involuntary combination. For example, if combination is required, an affiliated group may be able to contend that it is not engaged in a unitary business. If such contention is supported by the facts, the affiliated members will be permitted to file separate returns, for a state cannot constitutionally require the combined reporting of nonunitary businesses.3 This recently occurred in AIG Insurance Management Services, Inc. v. Vermont Dept. of Taxes.4

The issue in AIG Insurance Management Services was whether a wholly owned subsidiary (primarily operating as a Vermont ski resort) had unitary operations with its multinational parent (principally engaged as an insurance and financial service business) so that the parent had to include the subsidiary in a unitary combined filing. The court concluded that although the parent had sole ownership and the ability to direct the subsidiary's operations (given the parent's power of appointment over the subsidiary's board members and exclusive financing role), the subsidiary was a distinct business operation. There was no evidence of a linkage of economic realities between the Vermont business enterprise and the parent's operations outside of Vermont. No interdependence of functions or use existed amounting to an exchange of value accruing to the parent across state lines. The parent met its burden of demonstrating that the subsidiary was not unitary with the rest of the parent's operations given that (1) there were no economies of scale realized by the entities' operations, (2) the subsidiary's business was not functionally integrated with the parent's business, and (3) the parent did not actually direct the subsidiary's policy or operations.

From a planning perspective, taxpayers should consider the feasibility of removing unitary relationships in anticipation of a forced combination attempt. Steps that can be taken to weaken unitary ties among companies include eliminating common officers and directors and reducing common administrative functions or centralized financing. When intercompany ties are widespread, however, those steps may not be practical, and other steps should be considered.

An affiliated group may also be able to argue that a state has exceeded its statutory authority in requiring the group to file on a combined basis. A recent example of this took place in Agilent Technologies, Inc. v. Colorado Dept. of Rev.5 The determinative issue in Agilent Technologies was whether the Colorado Department of Revenue acted in accordance with the law in requiring the inclusion in a unitary combined return of a holding company with no property or payroll of its own. The relevant Colorado statute6 permitted the inclusion in a Colorado combined return of any C corporation with more than 20 percent of its property and payroll assigned to locations inside the U.S. A Colorado regulation7 interpreted the application of the Colorado statute to corporations with no property or payroll, and concluded that such corporations, by definition, could not be included in a combined return. Based on the wording of the statute and regulation, as well as apparent legislative intent, the court held that Colorado erred when it required the inclusion of the holding company in the unitary combined return.

In the context of forced combination, more states are considering adding tax haven company provisions to their combined reporting laws. For example, Connecticut's recent unitary legislation (effective for income years beginning on or after Jan. 1, 2016) provides that a combined group filing on a water's edge or affiliated group basis must include commonly owned unitary companies incorporated in a tax haven. A tax haven company may be excluded from the combined group if the company can establish that it was incorporated in the tax haven for a legitimate business purpose. The legislation sets forth five factors that define a tax haven, and states that irrespective of the five factors, a tax haven does not include a jurisdiction that has entered into a qualifying comprehensive income tax treaty with the U.S.8 As the states continue to look at combining tax haven companies, potential constitutional challenges may arise related thereto.

Statutory Disallowance

As previously noted, intercompany transactions between members of a combined income tax return at the state level are generally eliminated in computing the tax base. However, many states lack the authority to compel the filing of a combined report. Furthermore, even in those states with such authority, certain affiliated entities, such as those not engaged in a unitary business, may not be required or permitted to file in the same combined return. In this regard, intercompany transactions between related entities are generally eliminated only if both entities are members of the same combined return. Therefore, the states have focused on alternative methods to combination to reattribute income and expenses among related entities.

A number of states address intercompany pricing issues by statutorily disallowing certain intercompany expenses. These “anti-passive investment company” provisions are usually quite detailed and complex, and generally apply to transactions with investment or holding companies, rather than transactions with operating companies. The typical legislation generally disallows otherwise deductible interest expense and intangible expenses, such as royalties, resulting from certain related-party transactions. The typical legislation also generally contains exceptions whereby taxpayers may overcome intercompany expense disallowance adjustments in certain instances. However, these exceptions are often burdensome and confusing for taxpayers to meet.

For example, in a recent decision, Kohl's Department Stores, Inc. v. Virginia Dept. of Taxn.,9 the court addressed the extent to which royalties paid by a retailer to an affiliate fell within the safe harbor exception of Virginia's add-back statute. The statute provided, in relevant part, that there shall be added (to the extent excluded from federal taxable income) the amount of any intangible expenses and costs directly or indirectly paid, accrued or incurred to, or in connection directly or indirectly with one or more direct or indirect transactions with one or more related members to the extent such expenses and costs were deductible or deducted in computing federal taxable income for Virginia purposes.10 The statute further provided, in relevant part, that this addition was not required for any portion of the intangible expenses and costs if the corresponding item of income received by the related member was subject to a tax based on or measured by net income or capital imposed by Virginia, another state or a foreign government that had entered into a comprehensive tax treaty with the U.S. government.11

The retailer argued that under the plain meaning of the add-back statute, if income was included in the computation of a corporation's taxable income in another state, then that income was subject to tax. Based on that interpretation, the retailer argued that because the affiliate included the royalty payments it received from the retailer in income filings in other states, the royalties were subject to tax in other states and fell within the safe harbor exception. The retailer therefore insisted that no portion of the royalties it paid to the affiliate should be added back to the retailer's taxable income, even if the amounts listed by the affiliate in other states were not actually taxed in those states.

The court disagreed with the retailer's interpretation of the add-back statute, stating that to fall within the safe harbor exception, tax actually had to be imposed in another state on the intangible expenses paid to the related member. The court found this reading of the statute consistent with the legislative intent in enacting the statute and its exceptions (i.e., to close a corporate tax loophole and ensure that income attributable to Virginia was taxed).

As noted above, the typical statutory disallowance legislation generally requires an in-state operating company to add back deductions for interest and royalty payments made to related parties unless certain exceptions are met. Some states are enacting related-party add-back legislation that expands the scope of deductions subject to statutory disallowance. For example, Louisiana recently enacted legislation12 (effective for tax years beginning on or after Jan. 1, 2016) that requires the add back of related-party management fees in addition to interest expense and intangible expenses unless certain exceptions are met. It would not be surprising to see the states continue to broaden the types of intercompany transactions subject to statutory disallowance moving forward.

State §482-Type Audits

The I.R.S. places a great emphasis on transfer pricing as a source of revenue for the federal government. Similarly, many states directly audit intercompany transactions to reattribute income and expenses among related entities. At the state level, §482-type adjustments are generally applied to clearly reflect income between related entities doing business in different states. Many states have obtained authority to adjust the pricing of intercompany transactions by enacting statutes or regulations similar to I.R.C. §482. Alternative authority to perform, in effect, a federal audit at the state level is derived from the fact that some states that use federal taxable income as the starting point for computing state taxable income presume that the correct measure of the state tax base is income required to be reported to the federal government. Under such a presumption, the state takes the position that an audit of the federal base is appropriate.

From a planning perspective, taxpayers should carefully monitor the applicable statutes, regulations, rulings and cases in the various states with respect to §482 authority. In certain instances, the adjustments proposed by a state have been determined to go beyond the scope of adjustments that would be permitted at the federal level under I.R.C. §482. In other instances, a state's proposed adjustments may be well within the permitted scope of I.R.C. §482, but the state grant of authority to make such adjustments is not as broad as that permitted under the federal statute.

Moreover, properly prepared taxpayers can successfully contest the validity of a state §482-type adjustment. As a preliminary matter, each participant in an intercompany transaction must be a separate, viable entity, and not simply a shell or paper corporation. Each participant should be established for specific business and legal purposes to support its formation and existence. These business and legal purposes should be documented prior to formation. Furthermore, intercompany transactions must be performed on an arm's-length basis. Where appropriate and economically feasible, appraisals and/or arms-length pricing studies should be utilized to document and support the pricing of intercompany transactions. Ideally, such appraisals/studies should be undertaken prior to engaging in the transactions to best substantiate the arm's-length conduct of the participants. In the absence of an appraisal/study, a federal closing agreement under I.R.C. §482 can substantiate arms-length pricing, although the states are not generally bound to accept the federal findings.

In a coordinated effort to share resources and expertise, the states have been working with the Multistate Tax Commission (MTC) over the past couple of years on developing a high quality, viable design for an Arm's-Length Adjustment Service (ALAS). A stated mission of the ALAS initiative is to provide states with timely, cost-effective services and opportunities for interstate cooperation to help attain equitable compliance from corporate taxpayers with state business taxes in circumstances where improper related-party transactions undermine equity in taxation. The design for the ALAS entails two broad components. The first component involves using advanced economic and technical expertise to produce analyses of taxpayer-provided transfer pricing studies and, where appropriate, to recommend alternatives to taxpayer positions taken based on those studies. The second component involves enhancing the ability of states to use this expertise and the resulting analyses effectively in addressing cases of income shifting through related-party transactions. This second component contemplates training state staff, establishing information exchanges, helping states improve their tax administrative and compliance processes, expanding audit coverage for related-party transactions in the MTC Audit Program, providing assistance to states in developing and resolving cases, and supporting states in defending their work in litigation.

The implementation of the ALAS was initially targeted for July 1, 2015. States wishing to participate in the ALAS project were asked to make a four-year commitment. The anticipated budget for the ALAS project over the first four years is approximately $2 million annually, or an average of approximately $200,000 per state per year based on ten participating states (actual state costs would vary based on state size and usage of services). In light of an insufficient number of state commitments to the ALAS project (generally based on state concerns over costs in relation to potential monetary benefits), implementation of the ALAS has been delayed while state recruitment continues.

Alternatives are currently being considered to make the ALAS project less resource-intensive in order to move the project forward. In this regard, certain activities were recently identified that could be undertaken prior to obtaining sufficient state commitments to formally launch the ALAS project. These “early implementation steps” include training for state staff, exchanges of taxpayer information, and interstate discussions of pending taxpayer cases involving important arm's-length issues. The purpose of the early implementation steps would be to assist states in improving their compliance activities with respect to cases involving arm's-length issues, and to develop further knowledge and understanding among the states and the MTC to help tailor ALAS activities and implementation to best serve state needs.

Economic Nexus and Affiliate Nexus

Nexus is the contact necessary to subject an entity to a state's taxing authority. Generally, an entity will have income/franchise tax nexus if it has a physical presence in a state (i.e., maintains real or tangible personal property, stores inventory and raw materials, or establishes an office in a state) or performs services in a state. Of course, an entity will not have nexus if its activities in a state are within the scope of protection afforded by the federal Interstate Income Tax Law, Pub. L. No. 86-272.13

In recent years, the states have aggressively expanded the principle of nexus to include economic nexus and/or nexus via an affiliate operating in the state. Under these theories, an entity with no physical presence in a taxing state can still be subject to tax if the entity has purposefully directed its activity at the state's economic forum (generally through affiliated entities). The case that originally brought nationwide attention to these issues was Geoffrey, Inc. v. South Carolina Tax Comn.14 Since Geoffrey, economic nexus and/or nexus via an affiliate operating in the state have become frequently litigated topics.

A recent high profile case examining an economic/affiliate nexus dispute in great detail is Harley-Davidson, Inc. v. California Franch. Tax Bd.15 The petitioner in Harley-Davidson engaged (through various subsidiaries) in a motorcycle business and a financial services business. On the financial services side, one subsidiary, a holding company, provided administrative services to its affiliates. Another subsidiary (hereinafter referred to as loan servicing subsidiary) acquired and serviced loans made to purchasers of petitioner's motorcycles. The loan servicing subsidiary had no offices or property in California, and none of its employees were based there. The loan servicing subsidiary performed collection activities if payments on a loan were not made timely or fully. If collection efforts were not successful, the loan servicing subsidiary hired third parties to repossess the motorcycles securing the loans. Some repossessed motorcycles ended up at auction houses, and an employee of the loan servicing subsidiary visited an auction house in California on 17 days to assist in setting prices for motorcycles or to observe some part of the auction process. The loan servicing subsidiary also made wholesale loans to dealers of petitioner's motorcycles for inventory purchases and showroom upgrades.

Two subsidiaries (hereinafter referred to as special purpose entities), wholly owned by the loan servicing subsidiary, were created to securitize loans for the loan servicing subsidiary. The special purpose entities had no offices or property in California, had no employees, and did not advertise or solicit business in California. Each special purpose entity was formed to exist as a corporation distinct from petitioner's other entities. Each special purpose entity had two independent directors (out of four), kept separate records and accounts, paid its own expenses, was adequately capitalized, and earned a reasonable rate of return on securitization transactions.

To generate liquidity, the loan servicing subsidiary securitized a portion of the consumer loans it purchased. The loan servicing subsidiary could not directly securitize the loans without exposing investors to the risks (particularly the bankruptcy risk) associated with the petitioner's business. Consequently, approximately two or three times per year, the loan servicing subsidiary identified and sold a pool of loans (the loan pools contained more loans from California than any other state) to either of the special purpose entities which included a security interest that permitted repossession of the underlying motorcycles.

Pursuant to written agreements, the special purpose entities established trusts capable of issuing securities. After purchasing loan pools from the loan servicing subsidiary at fair market value, the special purpose entities sold the loan pools (with security interests) to the trusts. The trusts then issued securities backed by the loan pools. Third party underwriters purchased the securities from the trusts, marketed the securities, and resold the securities in the open market. As owners of the loans (through the trusts), the special purpose entities were responsible for servicing the loans. To accomplish this, the special purpose entities entered into servicing contracts with the loan servicing subsidiary, which serviced the loans on behalf of the special purpose entities for a fee.

The petitioner contested the position of the Franchise Tax Board that the special purpose entities were taxable by California. Specifically, the petitioner contended that the activities of the special purpose entities were insufficient to establish nexus in California in light of due process and commerce clause limitations on taxing foreign entities. The court disagreed, however, finding that although the special purpose entities were legally separate entities from the loan servicing subsidiary, there was an agency relationship between the special purpose entities and the loan servicing subsidiary. Based on this agency relationship, the court held that the special purpose entities were taxable by California, as they had a sufficient nexus with California to satisfy due process and commerce clause concerns.

The court cited the following evidence in support of the agency relationship between the special purpose entities and the loan servicing subsidiary: (1) the special purpose entities were only formed so the loan servicing subsidiary could obtain more favorable pricing from securitization investors than the loan servicing subsidiary could obtain by directly securitizing the loans; (2) the special purpose entities were governed by directors and officers who were also directors and officers of the loan servicing subsidiary; (3) the special purpose entities had no employees of their own, but rather acted entirely through loan servicing subsidiary employees; (4) the special purpose entities were only permitted to securitize loan servicing subsidiary loans; (5) the loan servicing subsidiary selected the pool of loans to securitize, administered the sale of the special purpose entities' securities to underwriters, and indemnified the underwriters; (6) the loan servicing subsidiary undertook collection activities on the special purpose entities' loans; and (7) it was a loan servicing subsidiary employee who visited an auction house in California on 17 days to assist in the auction process (a process designed to ensure the value of the collateral securing the loans held by the special purpose entities).

The court concluded that through the actions of the loan servicing subsidiary (as agent), the special purpose entities had minimum contacts with California such that taxation of the special purpose entities by California did not offend traditional notions of fair play and substantial justice as required under the due process clause. The court further concluded that since the loan servicing subsidiary (as agent) sent an employee to auctions in California on 17 separate occasions (conduct that was integral and crucial to the business of the special purpose entities and not de minimis), a substantial nexus was established as required under the commerce clause.

Business Purpose and Economic Substance

It is important to note that in structuring intercompany transactions, taxpayers must take into account the overriding principles of business purpose and economic substance. The business purpose doctrine requires that transactions have a bona fide business purpose apart from tax avoidance. The economic substance doctrine looks to whether there is the possibility of a profit, and whether the transaction is a mere book entry or entails additional activities. The concepts of business purpose and economic substance may be invoked to question a transaction or structure if: (1) the entities involved serve no business purpose other than tax avoidance; (2) the transaction or structure is not bona fide; (3) the entities involved do not maintain separate identities and ignore corporate formalities; and/or (4) one entity to the transaction or structure controls the other entity.

The concepts of business purpose and economic substance are generally utilized by states to negate the literal reading of a statute or regulation that produces a result that is deemed unfair or inappropriate. These concepts often come into play when challenges to the deductibility of expenses or the disallowance of other tax benefits in connection with tax motivated transactions or structures occur. Some states have even passed legislation specifically authorizing a business purpose/economic substance analysis to taxpayer transactions or structures. For example, in Massachusetts, the commissioner may disallow the tax consequences of a transaction by applying the sham transaction doctrine or any other related doctrine. If the commissioner exercises this authority, the taxpayer must demonstrate that: (1) the transaction has a valid, good faith business purpose other than tax avoidance; (2) the transaction has economic substance apart from the asserted tax benefit; and (3) the asserted nontax business purpose is commensurate with the tax benefit claimed.16

There has been a great deal of controversy throughout the country relating to the issue of whether a transaction or structure has business purpose or economic substance. Although there is much litigation in the area, judges have struggled to articulate what constitutes business purpose and economic substance, and the distinction between them is often blurred. The difficulty in determining whether sufficient business purpose or economic substance exists is plainly illustrated by the opposite conclusions that different states draw from identical fact patterns. For example, in the case of Sherwin-Williams, Massachusetts17 held that certain intangible property transfer and license-back transactions were not shams and had economic substance, while New York State18 found there was no economic substance to the same intercompany transactions. Similarly and more recently, Maryland19 reviewed a fact pattern involving ConAgra Brands and determined that an out-of-state intellectual property licensor lacked economic substance as a separate entity apart from its parent corporation (which in the court's view legally justified taxation of the licensor). West Virginia20 evaluated substantially identical facts, and concluded that the licensor was not a shell corporation (and taxation of the licensor violated the due process and commerce clauses of the U.S. Constitution).


In light of the foregoing, taxpayers must pay close attention to the state tax implications of intercompany transactions. In this regard, taxpayers should certainly evaluate and utilize all planning strategies available to minimize the overall tax liability. In conjunction therewith, taxpayers should also develop and implement appropriate measures to credibly justify and defend all filing positions taken with respect to intercompany transactions.

1 I.R.C. §1501 et. seq.

2 Treas. Regs. §1.1502-13.

3 SeeContainer Corp. of America v. California Franch. Tax Bd., 463 U.S. 159 (1983).

4 2015 VT 137 (2015).

5 No. 2014CV393, Colo. Dist. Ct., Jan. 20, 2016.

6 Colo. Rev. Stat. §39-22-303(12)(c).

7 Colo. Code Regs. §39-22-303.12(c).

8 L. 2015 §140.

9 No. CL12-1774, Va. Cir. Ct., Feb. 3, 2016.

10 Va. Code §58.1-402(B)(8)(a).

11 Va. Code §58.1-402(B)(8)(a)(1).

12 La. Rev. Stat. §47:287.82.

13 73 Stat. 555 (1959), in U.S. Code §381. Pub. L. No. 86-272 prevents a state from imposing its income tax on a taxpayer whose only activity within the state is soliciting orders for the sale of tangible personal property, provided these orders are sent outside the state for approval and, if approved, are filled and delivered from a stock of goods located outside the state. Pub. L. No. 86-272 applies only to the imposition of state income taxes and to entities that derive their income from the sale of tangible personal property rather than intangible property or services.

14 437 S.E.2d 13 (S.C. 1993), cert. denied 510 U.S. 992 (1993).

15 187 Cal.Rptr.3d 672 (2015), app. denied (on nexus issue) Cal. S. Ct., No. S227652, Sept. 16, 2015.

16 Mass. Gen. L. Ch. 62C, §3A.

17 The Sherwin-Williams Co. v. Massachusetts Comr. of Rev., 778 N.E.2d 504 (2002).

18 In re The Sherwin-Williams Co., No. 816712 (N.Y. Tax App. Trib. June 5, 2003), aff'd., Sherwin-Williams Co. v. New York Tax App. Trib., 784 N.Y.S.2d 178 (2004), app. denied 4 N.Y.3d 709 (N.Y. Ct. App. 2005).

19 ConAgra Brands, Inc. v. Maryland Comp. of Treas., Md. Tax Ct., No. 09-IN-OO-0150, Feb. 24, 2015.

20 West Virginia State Tax Comr. v. ConAgra Brands, Inc., 728 S.E.2d 74 (W.Va. 2012).