Although U.S. multi-state transfer pricing enforcement is not a new concept, the intercompany pricing of transactions between U.S. entities located in different states, and the associated support for such pricing, may not intuitively top the list of important tax considerations for many U.S. corporations. Historically, non-unitary states have used various approaches to address the potential for multi-state taxpayers to use transfer pricing to reduce state income tax burdens (e.g., forced combination, related-party addback, alternative appointment and nexus assertion) with limited success. Taxpayers, on the whole, have been successful in arguing against these states’ efforts to combat the effects of intercompany transactions on state tax burdens, and state tax authorities have consistently been required to adhere to federal transfer pricing regulations (codified under the Internal Revenue Code (IRC) section 1.482). In 2015, the Multi-state Tax Commission (MTC) created an initiative in which member states would share information and train audit teams to more successfully dispute corporations’ domestic transfer pricing practices. At that time, only 12 states had adopted the MTC’s initiative, and the MTC’s transfer pricing committee (the State Intercompany Transactions Advisory Service) had failed to gain widespread state support.
However, with COVID-19 and the resultant strain on states’ revenues and costs, the pricing of domestic intercompany transactions has once again become a focus for state tax authorities looking to ensure that income is appropriately taxed within their state. Based on an analysis by the National Conference of State Legislatures,1 state revenue from corporate taxation represented only 4.8% of the total state tax collections in 2018, down from 9.4% in 1981, with analysts predicting that states are likely collecting only about a third of what is actually owed. In the past, states have posited that the decrease in corporate tax collection was due, in part, to the tax planning of corporations, locating high value assets in subsidiaries incorporated in lower tax jurisdictions (e.g., Washington, Nevada, Wyoming, South Dakota and Ohio that do not tax corporate income). Transfer pricing, as conducted under the federal application of IRC Section 1.482 (U.S. Transfer Pricing Regulations), has historically been relegated to an alternative method to be used in challenging state corporate income tax returns, when traditional state tax methods proved unsuccessful. Given their recent losses in state tax courts,2 state tax authorities (particularly those located in the southeast) have made several changes to their approach to transfer pricing to bolster their capabilities and reach.
Renewed State Transfer Pricing Efforts
Most states generally provide broad discretionary powers to the State Commissioners of Revenue, allowing for adjustments that follow the principles described under the U.S. Transfer Pricing Regulations. However, state tax authorities have historically chosen a state-specific approach in the form of forced combined reporting, addback of related-party expenses, alternative apportionment, and/or nexus assertion. In addition, very few states have the experience or technical resources required to properly evaluate transfer prices. State revenue office-led transfer pricing studies, using an approach outside of the U.S. Transfer Pricing Regulations, have had difficulty prevailing against a transfer pricing study consistent with those regulations prepared by the taxpayer. As a result, states are turning their attention to the use of the U.S. Transfer Pricing Regulations as a tool to help capture lost revenue due to potential tax base erosion, and to help offset broader losses in tax revenues and increased costs associated with COVID-19. Recent actions employed by the states to this end include:
- Transfer Pricing Resolution Initiatives: The Indiana Department of Revenue (IN DOR) formed a transfer pricing group within its Audit Operations practice in 2018. Since that time, the IN DOR created an advance pricing agreement (APA) program in early 2020, modeled after the federal APA program that deals with international cross-border transactions, to offer taxpayers an avenue for resolving existing and potential transfer pricing disputes with the state directly. On July 30, 2020, the North Carolina Department of Revenue (NC DOR) announced that it would offer a similar program in which companies could voluntarily disclose their transfer pricing approach and settle on agreed pricing with the NC DOR. Although both programs are voluntary, many practitioners believe this is the start of a more concentrated effort by state tax authorities to investigate its corporate residents’ transfer pricing.
- State Collaboration and Information Sharing: The 12 member states3 of the MTC’s 2015 initiative continue to collaborate, sharing information and conducting training sessions geared toward continued improvement to audit procedures and capabilities in enforcing the arm’s-length standard. In March 2019, 16 states participated in an MTC-led training on transfer pricing. Currently, the IN DOR transfer pricing team works with a collaborative group of 13 states to share information regarding the transfer pricing administration to ensure continued improvement to its procedures and capabilities in enforcing the arm’s-length standard.
- Engagement of External Transfer Pricing Expertise: Alabama, North Carolina and Louisiana have entered into contracts with an independent transfer pricing consulting and database firm to assist in supporting the state’s transfer pricing enforcement efforts and to further build out its audit and dispute capabilities. In a similar vein, Massachusetts has retained outside counsel and economists, including former U.S. treasury and IRS counsel. The IN DOR engaged the services of an expert economist, which has significantly improved its performance and capabilities in this area, and Connecticut has hired two firms to provide transfer pricing training to its personnel.
Anticipating that these initiatives will result in some level of success in capturing additional revenue from state taxpayers, we would expect additional states to employ similar initiatives and engage in even greater information sharing and cooperation.
Impact of State Focus on Transfer Pricing
The increased focus on multi-state transfer pricing and resulting initiatives will primarily affect corporations that file in separate reporting states, such as Alabama, Arkansas, Delaware, Georgia, Florida, Indiana, Iowa, Louisiana, Maryland, Mississippi, Missouri, North Carolina, Oklahoma, Pennsylvania, South Carolina, Tennessee and Virginia.4 Taxpayers with significant tax impacts from interstate intercompany transactions involving these states should prepare themselves for increased scrutiny and potential for dispute. As with transfer pricing strategies in general, it’s always beneficial to be proactive in your defense and be in a position to state your company’s position (i.e., “tell your own story”) before an audit situation arises, forcing you to react to the state’s position.
In anticipation of the increased scrutiny on state transfer pricing, and with indications that states are preparing to take a more aggressive and capable stance on transfer pricing enforcement, companies that prepare separate returns or that have intercompany transactions that are not eliminated through the use of a consolidated or combined state tax return should similarly review and strengthen support of their domestic transfer pricing policies.
2.For example, courts have limited the state’s authority to reject transfer pricing studies and positions submitted by taxpayers in Columbia Sportswear USA Corp. v. Ind. Dept. of Revenue, 50 N.E.3d 147 (2016); E.I. Dupont de Nemours and Company v. Indiana Dep’t. of State Revenue, 79 N.E.3d 1016 (Ind. Tax Court 2017); and Utah State Tax Commission v. See’s Candies, Inc. 435 P.3d 147 (Utah 2018).
3.The 12 member states of the 2015 MTC initiative on transfer pricing include Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi, Missouri, New Jersey, North Carolina, Pennsylvania and South Carolina.
4.Of these states Alabama, Arkansas, Florida, Indiana, Iowa, Mississippi, Missouri, Oklahoma, South Carolina, and Virginia have an option to elect / request to file on a combined or consolidated basis.