Transfer Pricing Rough Justice for Hemorrhaging States

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Transfer Pricing

Aggressive transfer pricing has long been a fraught battleground for the Internal Revenue Service, which has lost several high profile tax cases involving the transfer of intangibles overseas. The same tax planning strategies that shift income to low-tax and no-tax jurisdictions overseas have implications for state tax revenue as well. However, states are poorly equipped to challenge companies on their transfer pricing. In a two-part series, Bloomberg BNA looks at the reasons why. Part one discusses the disadvantages that state revenue departments face in attempting to conduct transfer pricing audits. Part two will look at how the Chainbridge economic consulting firm's efforts to help states with audits ran aground in the District of Columbia.

By Dolores W. Gregory

Aug. 29 — Facebook Inc. made headlines recently when court documents came to light showing that the IRS believes the company understated its U.S. income by billions of dollars.

Facebook says it could be looking at an additional $5 billion in federal corporate income taxes.

Microsoft Corp. is also embroiled in an Internal Revenue Service audit of its transfer pricing. The agency has suggested that the computer giant might have understated its income by more than $30 billion over the course of several years.

Numbers like these raise eyebrows, but they also skirt a seldom-asked question: When a multinational company shifts intangibles offshore, what does that mean for the U.S. states where they do business?

The answer seems to be: Big money losses that states can't quite pin down and can't fight very effectively.

“It's hard to quantify what's not coming in,” says Marshall Stranburg, deputy executive director of the Multistate Tax Commission. “States have a sense that there is something going on out there, but I can't give you the magnitude of what we are talking about.”

Cross-Border Income Shifting

States have been dealing with cross-border revenue shifting for decades, Stranburg says, starting with mail-order companies that avoided sales tax collection duties in states where they had customers but no stores. The sales tax quandary intensified with the emergence of e-commerce.

In the late 1980s, multinationals began to embrace passive investment companies to house intangibles in low-tax and no-tax jurisdictions.

The most notorious structure was the so-called Delaware holding company. Multistate companies parked patents, trademarks, trade names and other intellectual property in a Delaware affiliate and charged operating companies in other states hefty licensing fees for the use of the intangibles.

More recently, multistate and multinational corporations have gotten more aggressive about using related-party structures to shift income.

“It's not just the licensing of intangibles,” Stranburg says. “It's purchasing of inventory, common services, payroll services, accounting services. It could be any number of things.”

Kimberly Robinson, secretary of revenue for Louisiana, told Bloomberg BNA that volatility in corporate income tax revenue has generated a lot of concern among states.

“States are trying to understand what's causing those fluctuations,” she says. “Is it the economy, is it tax planning?”

States have become more and more aware of different planning techniques that businesses are using to minimize their tax liabilities, she says. “The transfer pricing issue came up because of the amounts being paid for intangibles. How much was a trademark really worth? In addition to whether a trademark holding company had nexus in a state.”

Transfer Pricing Audits

States fought the Delaware holding company structure by adopting add-back statutes that disallowed deductions for intercompany licensing fees, but they found it hard to keep pace with taxpayers' ever-shifting strategies.

Today, more states are trying to fight aggressive transfer pricing head-on by challenging the intercompany pricing itself. But only the largest states, such as New York and California, have the resources to undertake the kind of complex, intensive audits that the IRS conducts routinely.

Smaller states have turned to outside experts for help, with mixed results.

The District of Columbia, for example, retained Fairfax, Va., contractor Chainbridge Software LLC to conduct a series of transfer pricing studies of multinational corporations operating in the District. Chainbridge at the time also had contracts with Alabama and New Jersey.

But the program ran aground when Microsoft Corp. successfully challenged a $2.75 million assessment based on a Chainbridge study. A series of other taxpayer challenges followed, and now the District's transfer pricing audits are on hold, pending the outcome of three cases involving major oil companies.

In the interim, the MTC has attempted to launch a program of its own to support states in conducting transfer pricing audits. But that project met with a lukewarm response. The agency needed 10 states to sign on and pay a $200,000 fee to support the program's $2 million budget; only six states joined, and one of those states dropped out.

But the MTC hasn't given up, Stranburg says.

“We won't see a full-blown implementation of the design,” he says, but the MTC group is now working on an information-sharing agreement and training of state auditors.

When it becomes clear there is some benefit to working together on the problem, he says, “maybe the number of states participating would grow.”

Stranburg adds: “Like anything else, you have to start somewhere.”

Revenue Losses

Exactly how much revenue states have lost to tax avoidance is hard to quantify. Citizens for Tax Justice estimates that U.S. multinationals have parked close to $2.4 trillion in accumulated profits offshore in tax havens, out of reach of any tax authority.

That sum represents as much as $695 billion in federal income taxes that have gone uncollected on those profits, CTJ estimates. By way of perspective, that is enough to keep the U.S. Highway Trust Fund solvent for the next 50 years.

Eric Cook, chief executive officer of Chainbridge, thinks that corporate tax compliance at the state level could be even worse than at the federal, because multistate corporations are adept at exploiting the disparities among state corporate income tax regimes.

Forty-six states and the District of Columbia impose a corporate income tax, with rates ranging from a low of 1 percent to a high of 12 percent, the Federation of Tax Administrators reports. Four states—Nevada, South Dakota, Washington and Wyoming—impose no corporate income tax at all.

One state—Delaware—offers a special tax break to companies organized specifically to serve as intangible holding companies.

These disparities enable multistate and multinational corporations to channel their profits into states with no income tax and channel their expenses into states where the tax burden is heaviest.

Citizens for Tax Justice: 20 `Non-Disclosing' Cos. Company NameUnrepatriated Income $Millions Pfizer $ 193,587 General Electric 104,000 International Business Machines 68,100 Merck 59,200 Google 58,300 Cisco Systems 58,000 Johnson & Johnson 58,000 Exxon Mobil 51,000 Hewlett-Packard 47,200 Chevron 45,400 Procter & Gamble 45,000 PepsiCo 40,200 Coca-Cola 31,900 United Technologies 29,000 Medtronic 27,837 Intel 26,900 Eli Lilly 26,500 AbbVie 25,000 Bristol-Myers Squibb 25,000 Danaher 23,500 Subtotal 1,043,624Source: Citizens for Tax Justice, “Fortune 500 Companies Hold a Record $2.4 Trillion Offshore,” March 3, 2016, available at

Cook has seen it happen—multistate companies reporting losses in every state and yet, magically, never going out of business. One of the offenders was a retail company whose stores were owned by an affiliated real estate investment trust in Nevada, to which it paid excessive rents. Those rents went untaxed because Nevada had no corporate income tax.

“And they had another subsidiary that handled personnel management,” Cook recalls.

The retail company leased all its employees from that subsidiary. Like the REIT, the employee leasing company was based in Nevada and paid no taxes on its earnings.

“So it was a retail company with no stores and no employees—and this was all set up for tax purposes,” he says. “But when they file the 10-K with their stockholders, they don't mention any of these subsidiaries.”

Sense of Income Shifting

Stranburg says states have a strong sense that income is being moved around, but they often lack the expertise to make sense of the transfer pricing. The easiest thing is to disallow the transaction, but that isn't necessarily good policy.

“In my opinion, states ought to be trying to get to the right answer,” Stranburg says.

James Wetzler, former commissioner of taxation and finance for New York state, says the fundamental problem for states is that it is expensive to conduct a proper transfer pricing study. Major accounting firms can charge anywhere from several hundred thousand dollars to several million dollars for such a study, says Wetzler, who retired in January 2013 as a director in the New York City office of Deloitte Tax LLP.

“It's easy to see why the states aren't motivated to spend the money, with no guarantee of a return on their investment,” he says.

For the District of Columbia, Chainbridge offered an affordable way to outsource the economic analysis needed to support transfer pricing audits, says Glen Groff, director of operations with the District of Columbia Office of Tax and Revenue.

In the early 2000s, the District, like many other states, was struggling to fight the effects of Delaware holding companies, he says.

“It's pretty well documented that there's been transfer pricing going on for years,” Groff says. But the District didn't have the economic expertise to challenge many of the suspect intercompany transactions.

The D.C. program launched in 2008 and proved to be fairly successful, he says. But a few years later, Microsoft Corp. won a decisive victory in the Office of Administrative Hearings (OAH). An administrative law judge, ruling on the taxpayer's motion for summary judgment, found that Chainbridge's method of analysis was invalid as a matter of law.

In a dispute involving BP Products North America, however, a District of Columbia Superior Court judge declined to follow the reasoning of the Microsoft decision. Instead, he scheduled the case for trial, and BP ended up settling with the District (19 DTR K-5, 1/29/14).

Several other cases are pending in OAH, and District officials say it will be some time before they are resolved.

MTC Transfer Pricing Project

The Chainbridge controversy was one factor prompting the MTC to start discussions about its own transfer pricing initiative.

Michael J. Bryan, former director of the New Jersey Division of Taxation, approached the MTC with the idea of creating a centralized transfer pricing audit program.

When Bryan was appointed in 2010, New Jersey had a contract with Teradata Operations Inc., for which Chainbridge had been a subcontractor. Bryan later terminated the contract, even though it had reportedly generated $72 million in assessments and, as of mid-2011, some $15 million in collections (67 DTR J-1, 4/9/12).

Bryan declined to comment for this article. However he told Bloomberg at the time that his intention was to bring the work in-house. Doing so proved to be more difficult than he anticipated..

“We just don't have the resources to attract that kind of talent to the state of New Jersey,” Bryan said in a December 2013 interview. “I thought if the MTC could centralize that effort with the support of some other states, maybe that would be a way to solve that problem for New Jersey and other states at the same time.”

The original goal of the MTC program—now called the State Intercompany Transaction Advisory Service—was to assist states with transfer pricing audits by providing economic and transfer pricing experts who could perform the technical analysis.

“States are handed these massive transfer pricing studies. How do you make heads or tails of them?” Stranburg asks. “A lot of states don't have the in-house expertise to go through those studies. Are proper comparables being used, proper pricing points being used?”

And while it makes sense for states to pool their resources, Stranburg says, it is also hard for states to justify that commitment without a guarantee of a payoff. For that reason, Stranburg acknowledges, the MTC transfer pricing program has been a tough sell for states.

“Running a large revenue agency is like running any kind of business. You have to look at the return versus what is invested. It would be a few years before we started seeing those returns,” he says.

Section 482 Authority

In its purest form, transfer pricing is an accounting mechanism—it represents the amount paid or charged for transactions among related parties in a corporate group.

Section 482 of the U.S. tax code authorizes the IRS to reallocate income, deductions, credits or allowances among companies in such a group if doing so will prevent the evasion of taxes or clearly reflect the income of the organization.

Many states have adopted Section 482 authority for their own revenue agencies, but few revenue directors rely on that authority to reallocate income. Instead, many states have found it easier to employ other means of fighting income shifting between related companies.

The Delaware holding company is a case in point. Though the structure involves transfer pricing, states have preferred to tackle it through add-back statutes.

Michael Mazerov, a senior fellow with the Center on Budget and Policy Priorities, a nonprofit research institute in Washington, explains the problem: “Delaware’s corporate income tax has a special provision that exempts from the tax corporations whose only activity is the ownership and management of intangibles,” Mazerov says. “So companies set up subsidiaries in Delaware for that sole purpose.”

For the Delaware holding company, the royalties charged for the use of the intangibles represent untaxed income. But for the operating company, the royalties are a deductible business expense.

Add-Back Statutes

States fought these structures by disallowing deductions for the royalties paid by the operating companies. But the add-back statutes tended to be very specific. They might apply to royalties for trademarks, for example, but not to other intercompany expenses, such as management fees or legal fees. It was hard for states to keep up with the ever-changing mechanisms for shifting income around.

The District adopted an add-back statute, but it proved not to be very effective, at least not initially, Groff says. “It was not very tightly drawn, and ultimately the District rewrote it.”

Joe Garrett, deputy commissioner of revenue with Alabama, who is leading the MTC's transfer pricing project, says Alabama adopted both a transfer pricing statute and an add-back statute about the same time.

In fact, Alabama contracted with Chainbridge for several years, starting in 2003, to conduct transfer pricing studies.

“Because we had the add-back statute, we did not pursue as many transfer pricing audits—or pursue it as aggressively as we would have,” he says.

The revenue department is no longer working with Chainbridge, he says, but not because of dissatisfaction with their services. At the time Alabama started working with Chainbridge, they were one of the few contractors who would provide transfer pricing services to states, Garrett says. Since then, more competition has popped up, and they were eventually outbid.

Alabama also decided to focus more on its add-back enforcement, which Garrett says is the state's preferred method of tackling income shifting. It relies on transfer pricing audits for transactions that don't involve intangibles and for which the add-back statute doesn't apply.

Separate Versus Combined Reporting

Recently, Garrett says he has seen a shift in the way companies are structuring intercompany transactions.

“Those simple intangible royalty transactions have gone away and are being replaced by more complicated structures,” he says.

In some cases, companies have taken to rolling the royalty prices for intangibles into the intercompany prices for goods—and states have to figure out how to unbundle the costs.

Mazerov says multistate corporations are able to take advantage of the differences in state corporate income tax structures. The solution would be to end separate entity filing, which is required in roughly half of U.S. states, including Alabama and New Jersey.

Under such regimes, members of a corporate group are required to file individually. In contrast, in combined reporting states such as California, members of corporate groups file tax returns that reflect the activities of the entire U.S. enterprise.

Currently, 25 states and the District of Columbia are combined reporting states, up from about 16 less than a decade ago, Mazerov says.

In those jurisdictions, combined reporting washes out the effects of cross-border transactions within a corporate group, Mazerov says.

And combined reporting solves another problem, he says, which is that even when the transfer pricing is correct—when the intercompany charges aren't inflated—companies can still use it for tax planning.

“The royalty can be absolutely what an arm's-length royalty should be,” he says. “So they are not doing anything the least bit illegal. But nevertheless, they are shifting income out of the state.”

These companies aren't in the business of licensing trademarks, Mazerov says. That isn't the purpose of the enterprise. “They are making money by selling goods or services to outsiders.”

As Mazerov sees it, the Delaware holding company is simply a mechanism to take advantage of separate entity filing in order to shelter income.

“Would the transaction occur at all, but for the fact that parts of the company have to be separately incorporated?” he says.

Advantages of Combined Reporting

Garrett agrees that companies doing business in both combined reporting and separate reporting states are able to exploit those differences to their advantage.

“Now the thing we see more of in the domestic context is shifting of income from separate return states like Alabama to combined return states,” Garrett says.

Doing so helps the business, he explains, because it lowers taxes in Alabama but has no impact on the tax in the state with combined reporting.

Moving to combined reporting could take care of a lot of the income shifting across jurisdictional lines, but it doesn't take care of the entire problem, says Stephen Cordi, deputy chief financial officer with the District of Columbia Office of Tax and Revenue.

The District shifted from separate returns to combined reporting in 2011, he says. “If it's working the way it should, it eliminates intrastate, garden-variety transfer pricing, where companies put their legal department in Delaware and charge Wall Street rates to subsidiaries and drain all the income back to Delaware where it isn't taxed.”

But it doesn't wash away the effects of international transfer pricing, he says. Multinational corporations can still shift income to foreign tax havens.

Mazerov agrees.

“By itself, if it's applied as most states do, on a water's edge basis, it nullifies income shifting across state borders,” Mazerov says of combined reporting. “But if you don't combine entities incorporated abroad, it doesn't do anything to stop international income shifting.”

Corporate Pushback

This is why, Mazerov says, a handful of combined reporting states have started to include subsidiaries formed in tax haven countries.

But as with the add-back statutes, the tax haven statutes have met with fierce pushback from business interests—something he finds particularly ironic.

“So many companies that you see lobbying fiercely against combined reporting, claiming that if the state adopts it, that will be the last investment they make in the state—in so many of those cases, those companies are happily filing year after year in other states and continuing to make investments in other states” that have combined reporting regimes, Mazerov says.

Ultimately, the best solution would be for every state to adopt a combined reporting regime, Mazerov says, but he acknowledges that the political barriers are high.

Wetzler agrees.

“States could all solve this problem by going to a combined reporting regime,” he says. “Then it wouldn't matter.”

But the main reason states don't is because of corporate lobbying, he says.

Alabama has considered several combined reporting bills over the years and always met strong opposition, Garrett says.

“Many arguments are of an economic development nature,” Garrett says. “That it would make Alabama a less attractive place to do business.”

That is the argument the Council On State Taxation made in New Jersey this spring when it lobbied against a bill to enact mandatory combined reporting in the state. COST, which represents 600 major U.S. corporations, decried S.B. 982 as a jobs killer that would lead to little additional revenue for New Jersey.

“Adopting combined reporting could have a significant negative impact on New Jersey’s regional competitiveness for attracting jobs and business investment,” COST says in a letter to the New Jersey Senate Budget and Appropriations Committee.

Mazerov is more cynical. Multinational corporations prefer a separate reporting structure, he says, because under it, “they have substantially free rein to shift income.”

Going Forward

Meanwhile, the MTC is continuing to hold meetings on its transfer pricing service. The committee plans to devote an October training session to case studies of intercompany structures and pricing strategies

Stranburg says he hopes more states will begin to see the value of a program to help them get a handle on income shifting across state borders.

“What we're trying to do here is provide states with some assistance,” he says. But it is a constantly shifting target.

“What we see today may not be what we see tomorrow. But the same things are going to be taking place. Things are going to be moving from companies to related companies. How do states look at that? What do they do?” he asks.

Garrett believes that states need to do something, even if only on a small scale. That at least will send a message to corporate taxpayers to pay more attention to their transfer pricing.

Most compliance is voluntary, he notes, and voluntary compliance always increases when states conduct audits.

“Particularly if the states work together,” Garrett says. “That would be enough of a threat of an adjustment, so that taxpayers would at least have some respect for the accuracy of their transfer pricing and not be uber-aggressive about it.”

Still, he admits, states are at a serious disadvantage when it comes to the battle against income shifting.

“I know I heard a talk from one of the partners at one of the large CPA firms,” he says. “He was talking about the MTC program and expressing some skepticism about it. The program as planned was three or four full-time people, and he said that the EY program had a couple of thousand people working in it. The states could get together and agree to pay three or four full-time people, and he was saying ‘you're not going to be able to compete or keep up.' And I think that's right. But what's the alternative?”

To contact the reporter on this story: Dolores W. Gregory in Washington at

To contact the editor responsible for this story: Ryan Tuck at

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