States Aggressively Going After Taxpayers on Transfer Pricing Audits

Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...

By Dolores W. Gregory

States are becoming more aggressive in their examination of transfer pricing among related companies, looking for new and better ways to challenge intercompany transactions, a panel of state tax specialists said at a Feb. 25 conference.

Transfer pricing audits are the latest tool in an arsenal that has included claims of economic nexus, agency nexus, add-back statutes, throwout, and other measures aimed at allowing states to tax income they should not be able to reach, said panelist Donald M. Griswold, partner in Reed Smith LLP.

Speaking at a conference sponsored by the Tax Council Policy Institute, Griswold said the justification for such policies is that they are necessary to correct “distortion.” However, he argued that in most instances “distortion is a myth.” True distortion only occurs when the intercompany pricing of a transaction is not at arm's length.

Systemic Distortion Is the Problem

“I'm trying to make people understand the critical distinction between transactional distortion and systemic distortion,” Griswold told BNA in a subsequent interview.

“The states' complaint is about systemic distortion,” Griswold explained. “When you have a separate filing system, any time you've got income and expense sides in different states, somebody may lose.”

In the typical transaction under attack by many states, a company pays royalties to an out-of-state affiliate for use of a trademark. If the out-of-state affiliate is based in a state without an income tax—such as Delaware—its royalty income is not taxed, while the income of the user is reduced by its royalty expenses.

Some separate-return states have characterized such transactions as abusive tax planning. But so long as the transaction is properly priced, Griswold said, “there's no taxpayer-specific distortion, because the income and expenses sides of the transaction are in balance.”

If states do not like the tax result, he said, the solution is not to challenge the transactions, but “to go unitary”—and require combined reporting.

“That is the only legitimate approach,” Griswold said.

He added, “it is disingenuous for states to mislabel systemic distortion as transactional distortion and then to alter the tax consequences of an undistorted transaction only when it helps the state and not when it hurts.”

Expect More Scrutiny, Panel Says

But in an era of yawning state budget deficits, taxpayers can expect states to continue to battle such transactions, the panel agreed. Many states are looking at transfer pricing audits as a field of opportunity, said panelist Colleen Warner, principal with Ernst & Young's Transfer Pricing Group.

Many tools and techniques commonly used in the international transfer pricing arena are now surfacing at the state level, Warner noted.

“What we've seen internationally is an effort to look at transfer pricing prospectively and put documentation in place,” she said. Now some states, like the IRS, are accepting such advanced pricing agreements.

One common method of evaluating transfer pricing is to look at the comparable profits of similar companies in an industry. If a taxpayer is in line with its industry, it can argue that its pricing is appropriate.

Efforts to ‘Unwind' Intangibles

But states can use the same method to argue the opposite case, Warner said. For example, some states have attempted to “unwind” intangibles in the context of transfer pricing, by carving out the value of a trademark from a transaction involving a tangible good, and then subjecting the value of the intangible to addback.

“If you use the comparable profits method to determine that a taxpayer's operating profit should be 4 percent,” she explained, “you might determine that to achieve this result, the taxpayer's widget should be priced at $100. Now I'm seeing states saying that $20 of the price of the widget represents the price of intangibles, and that it is subject to addback.”

In the current climate, Warner said, the taxpayer's best defense is to be vigilant about conducting “robust” transfer pricing studies, to update them frequently, and to take care in choosing the best method of analysis.

The “best,” she suggested, is not necessarily the method that provides the most favorable tax result, but the one that holds up under state scrutiny.

“From an audit perspective,” Warner said, “if you find yourself talking about your selection of comparables—that's a taxpayer who's already won.”

Request Weekly State Tax Report