In the long running dispute over the District of Columbia’s Office of Tax Revenue (OTR) transfer pricing audits, last month an Administrative Law Judge (ALJ) denied a motion for summary judgment brought by Hess, ExxonMobil and Shell Oil. In this case, these ‘Big Oil’ taxpayers sought to have the OTR’s Notice of Proposed Assessments (NOPAs) thrown out on the grounds that the analysis done by the OTR’s third-party vendor, Chainbridge Software LLC, was fundamentally flawed when it applied I.R.C. § 482 transfer pricing principles to the taxpayer’s activity in the District, as first reported (subscription required) by Sony Kassam in Bloomberg Tax’s Daily Tax Report.
As background, the OTR issued the NOPAs to the taxpayers for underpaid District corporate franchise taxes, after contracting with Chainbridge to perform transfer pricing analyses on their behalf. According to Chainbridge, Hess, ExxonMobil and Shell underpaid the District a combined $3.76 million in taxes during the 2007 through 2009 tax years. All three oil companies appealed these assessments and moved for summary judgment on grounds that the assessments were arbitrary and capricious.
The crux of the oil companies’ case rests on Chainbridge’s failure to differentiate between controlled and uncontrolled transactions when determining each company’s profit-to-cost ratios, as noted in Kassam’s article. Chainbridge utilized the comparable profits method (CPM), one of the six methods of determining whether transfer pricing transactions are being kept at arm’s length mentioned in Treasury Regulation Section 1.482-5.
However, in determining whether these companies utilized transfer pricing as a tax avoidance scheme, Chainbridge’s CPM analysis looked to the oil companies’ overall profits and compared them with that of its competitors. Because a CPM analysis is performed by comparing the operating profit of similarly situated taxpayers, the court held that “there was not necessarily a need for OTR to have separated or compared controlled transactions and uncontrolled transactions in conducting a CPM analysis, and OTR’s failure to do is not unreasonable, arbitrary, or capricious.”
Ultimately, the ALJ held that the taxpayers had failed to carry their burden in establishing that there was no genuine, material issue of fact. In doing so, the court found that the OTR’s argument that it was not feasible for Chainbridge to separate controlled and uncontrolled transactions was plausible.
So why did the District hire Chainbridge in the first place? As Bloomberg Tax's Lindsay Trasko noted, transfer pricing “allows entities to shift intercompany profits and changes the way [those profits] are reported on the entity’s tax return[;] [w]hen related entities file separate tax returns and use a separate method of reporting income, this profit shifting can result in unreported income, and thus lost tax revenue for the states.”
Many states are ill suited – both in resources and expertise – to combat this erosion in their revenue stream, so some states now contract with third-party service providers to conduct transfer pricing audits on their behalf. The OTR relies on third-party expert, Chainbridge, to perform transfer pricing analyses. Chainbridge has been in business for over a decade, “assisting state governments using federal transfer pricing regulations to enforce corporate tax compliance.” Chainbridge utilizes a proprietary software that reviews corporate tax information in order to generate a list of entities with profits margins that are questionably low for their industries. Taxpayers of interest to the states are then run through another software program that provides more detailed economic analysis focused on potential violations of I.R.C. 482 arm’s length standard.
As Bloomberg Tax’s Dolores W. Gregory stated, “In many ways, the Chainbridge story illustrates the overwhelming challenges facing states that take on aggressive tax planning by multinational corporations—particularly when it involves a mechanism as complex and imprecise as transfer pricing.” Many companies embroiled in fierce battles with states over their transfer pricing practices operate on a complex multinational business structure. In the context of the multinational oil and gas industry, there is an exchange of billions of dollars in commodities, equipment, intellectually property, and services among controlled affiliates, creating the potential for a staggering loss in revenue for the states in which these companies do business.
Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: Was the ALJ right to deny the taxpayers’ motion for summary judgment?
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 The Internal Revenue Service (IRS) relies on transfer pricing analyses to reallocate taxable income among related entities, and federal statutes and regulations have been promulgated to govern the use of such analyses; D.C. Official Code § 47-1810.03, contains nearly identical language to that of the federal statute aimed at keeping transfer pricing at arm’s length, I.R.C. § 482.
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