The MTC’s Transfer Pricing Program Is Fast Approaching
by Matthew P. Hedstrom and Chris Mehrmann
A surge in state transfer pricing audits could be on the horizon as the Arm’s-Length Adjustment Service (ALAS) Advisory Group of the Multistate Tax Commission nears completion of a proposed multistate transfer pricing service (ALAS program). Although the ALAS program has yet to be approved by the MTC Executive Committee, it is clear that the program is intended to be comprehensive, with the potential to impose significant compliance burdens on tax-payers.
Largely viewed as a federal/international issue, transfer pricing has become a priority for state tax administrators, given the amount of revenue purportedly escaping taxation. According to one estimate, state revenue loss from such income shifting approaches $20 billion per year.1In light of those reports, the states’ interest in protecting against base erosion is not surprising. However, given the various discre-tionary adjustments that states have used to attack perceived erosion and the relatively infrequent assertion of specific transfer-pricing-related adjustments to that point, the mo-mentum toward a robust transfer pricing program is some-what unexpected.
Simply put, transfer pricing refers to the mechanism used to establish the arm’s-length price of various intercompany transactions. These transactions commonly involve the transfer or licensing of intangibles (including patents and trademarks), the transfer of tangible goods (including in-ventory and supplies), loans, and management fees. Transfer prices are important because they help determine the taxable profits realized by different parts of a corporate group. When a transaction between related parties crosses jurisdic-tional boundaries, the transfer price can affect how each party’s income is allocated among the taxing jurisdictions.2 The MTC’s entrance into the transfer pricing arena arises against the backdrop of a line of District of Columbia cases involving taxpayer challenges to economic analyses ad-vanced by third-party economic consultants, which may have spurred MTC action. For instance, in Microsoft Corp. Inc. v. Office of Tax & Revenue, a District administrative law judge called an analysis produced by the government’s third-party contractor ‘‘useless.’’3
This article provides an overview of transfer pricing principles, summarizes the challenges for states in adminis-tering transfer pricing audits, and describes the ALAS pro-gram. There are several concerns that arise in connection with the proposed program, as well as steps taxpayers should take to better prepare for a state transfer pricing audit.
I. The MTC’s Stated Need for the ALAS Program According to the member states of the ALAS Advisory Group, the perceived aggressive use of transfer pricing on corporate tax returns has had a major fiscal impact on the states.4Although that impact is difficult to quantify, several states estimate that they could recover $5 million to $10
1Dan Bucks, ‘‘Preliminary Design for an MTC Arm’s-Length
Adjustment Service,’’ Dec. 2, 2014, at 3.
2To illustrate, suppose a corporation manufactures goods at a
factory in Pennsylvania, a separate reporting state with a top corporate income tax rate of 9.99 percent, and sells them in Virginia, which has a top rate of 6 percent. By placing the factory in a subsidiary and paying an artificially low price for the manufactured goods, the corporation could conceivably shift income from Pennsylvania to Virginia, produc-ing a lower overall state income tax burden.
3Microsoft Corp. Inc. v. Office of Tax & Revenue, No.
2010-OTR-00012 (D.C.O.A.H. May 1, 2012) (commenting on adjustments proposed by Chainbridge Software Inc. for the District of Columbia’s Office of Tax and Revenue).
4Bucks, supra note 1, at 2.
Chris Mehrmann Matthew P. Hedstrom
Matthew P. Hedstrom is a senior associate in the New York office of Alston & Bird LLP. Chris Mehrmann served as a Georgetown University Law Center extern with the firm in 2014.
In this article, Hedstrom and Mehr-mann examine transfer pricing prin-ciples, states’ challenges when admin-istering transfer pricing audits, and the Multistate Tax Commission’s pro-posed arm’s-length adjustment service program.
AUDIT & BEYOND
state tax notes
™million annually in lost revenue.5Cutting the low end of that range in half to generate a conservative estimate, Dan Bucks estimates that 10 states could anticipate collectively recovering $25 million annually through the ALAS pro-gram.6
The transfer pricing issues, member states say, are sub-stantially more complicated than the income-shifting cases of the 1980s and 1990s, which primarily involved economic nexus challenges and related-party addbacks.7According to the states, a primary driver for the ALAS program is their inability to distinguish between proper and improper in-come shifting arising from intercompany transactions on corporate tax returns.8 While most businesses routinely retain well-paid economic experts to determine the fair market value of transferred assets, states have been reluctant to invest in such costly and detailed analyses. By virtue of the ALAS program, member states intend to reduce the costs of retaining such reports by working together to obtain those services.
As noted, to address their lack of resources and experi-ence in the transfer pricing area, several states and the District have turned to outside contractors to assist with examinations. Those analyses, however, are technically defi-cient. For example, in Microsoft, a District ALJ held that the transfer pricing analysis submitted by the Office of Tax and Revenue (OTR) was arbitrary, capricious, and unreason-able.9To support its claim that Microsoft was improperly shifting income out of the District, the OTR submitted a transfer pricing analysis by Chainbridge Software Inc.10
Chainbridge purportedly based its analysis on the com-parable profits method set forth in the Treasury regulations for determining an arm’s-length transfer price.11However, the judge found that Chainbridge’s analysis failed to comply with the regulations in several respects.12Notably, the judge found that Chainbridge failed to segregate in its analysis Microsoft’s controlled transactions — that is, Microsoft’s related-party transactions — from its uncontrolled transac-tions. OTR and Chainbridge sought to justify that im-proper aggregation of all of Microsoft’s income by arguing that Microsoft’s business structure was so ‘‘complex and entangled’’ that the only proper way to analyze Microsoft’s controlled transaction was to include everything. Rejecting
that argument, the judge declared that ‘‘Chainbridge’s fram-ing of the data renders the analysis useless in determinfram-ing whether Microsoft’s controlled transactions were conducted in accordance with the arm’s length standard.’’
Other taxpayers have similarly challenged OTR assess-ments using Chainbridge’s method. For example, in BP Products North America v. District of Columbia, the taxpayer — relying on Microsoft — also argued that Chainbridge misapplied federal transfer pricing principles by aggregating both controlled and uncontrolled transactions to determine an adjustment to income.13 At issue in that case was a $722,585 assessment of corporate franchise taxes for 2006 through 2008.14Two weeks before trial, however, the parties settled the case for $581,600.15
More recently, a District ALJ struck down corporate franchise tax assessments against three major oil companies — each relying on transfer pricing analyses prepared by Chainbridge — on the ground that Chainbridge’s method was previously ruled invalid in Microsoft.16The judge held that collateral estoppel precluded the OTR from relitigating whether Chainbridge’s practice of aggregating a taxpayer’s controlled and uncontrolled transactions was permitted un-der the relevant regulations.17
II. Overview of the Proposed ALAS Program The ALAS program’s intent is to create a dedicated transfer pricing service that would facilitate multistate tax audits by providing, among other things, both training programs for state tax administrators and a cost-effective means for obtaining access to economic experts.
The draft design of the ALAS program anticipates that the program will provide a wide range of services, including training of state staff; more affordable access to outside economic experts; a confidential taxpayer information shar-ing program; an early voluntary disclosure period; an alter-native dispute resolution program; litigation support; and an optional joint audit program.18
The draft design calls for an initial four-year charter period for the ALAS program, commencing in mid-2015.19 During the first year of the charter period, it is proposed that
5Id. 6Id.
7Alston & Bird LLP, ‘‘State & Local Tax Advisory: The MTC’s
Transfer Pricing Audit Program Comes Into Focus,’’ Oct. 15, 2014.
8Bucks, supra note 1, at 3. 9Microsoft, No. 2010-OTR-00012. 10Id.
11The District of Columbia, like many states, has a transfer pricing
statute modeled after section 482 and therefore refers to the federal regulations for guidance in transfer pricing matters. Microsoft, supra note 3. The comparable profit method is set forth in Treasury reg. section 1.482-5(a).
12Microsoft, No. 2010-OTR-00012.
13BP Products North America Inc. v. District of Columbia, No.
2011cvt10619 (D.C. Super. Ct. 2012), discussed in Maria Koklanaris, ‘‘BP Settles Transfer Pricing Case With D.C. Tax Office,’’ State Tax
Notes, Feb. 3, 2014, p. 266. 14Id.
15Koklanaris, ‘‘District to Refund $140,000 in BP Transfer Pricing
Case,’’ State Tax Notes, Apr. 7, 2014, p. 15.
16Exxon Mobil Oil Corp. v. District of Columbia, No.
2011-OTR-00049 (D.C.O.A.H. Nov. 14, 2014); Hess Corp. v. District of
Colum-bia, No. 2012-OTR-00027 (D.C.O.A.H. Nov. 14, 2014); Shell Oil Co. v. District of Columbia, No. 2011-OTR-00047 (D.C.O.A.H. Nov.
14, 2014).
17Id.
18Bucks, supra note 1, at 10-22. 19Id. at 5.
the MTC hire four new staff members — a tax manager, an economist, an attorney, and a pricing auditor — who would work exclusively on matters pertaining to the ALAS pro-gram.20During the charter period, the MTC would retain additional staff to increase the program’s capacity for par-ticipating in audits.21 If operated as planned, the ALAS program would complete its first round of economic analy-ses by June 2016.22
The primary impetus for the ALAS program, according to the proposed design, is the need for a cost-effective means of obtaining economic expertise for transfer pricing pur-poses.23To control costs, the draft design proposes that the ALAS program use a combination of outside economic consultants and MTC staff to generate economic reports, with the MTC staff gradually taking a larger share of the workload as they gain experience.24It is anticipated, how-ever, that the ALAS program will always rely, at least in part, on outside economic consultants.25
A critical component of the ALAS program is its robust training program. It is intended that the training program will offer formal courses that address both the specific skills needed by state staff — including, for example, identifying audit issues and securing documents — and the general topics of related-party tax law and compliance administra-tion.26In addition to the formal courses, it is proposed that the ALAS program hold periodic interstate conferences to encourage collaboration and information sharing among the states.27
Another notable aspect of the program is its proposed six-month voluntary disclosure period for taxpayers seeking to resolve related-party issues.28The taxpayer application period for a voluntary settlement would start in July 2016 and end in December 2016.29The ALAS program would then process disclosure applications with a target of com-pleting agreements by March 2017.30
Although the draft design has been well received by the member states, the states have repeatedly expressed concern over the cost of the ALAS program, projected at about $2 million per year.31 For example, during the October 7, 2014, advisory group meeting, Marshall Stranburg, execu-tive director of the Florida Department of Revenue,
sug-gested that the group develop a business case — including an estimate of how much revenue the program would re-cover — to persuade others in state government to fully commit to the program.32 Similarly, at the suggestion of New Jersey, the early voluntary disclosure period was added to the program, in part to help generate revenue early on.33 The advisory group presented the draft design for the ALAS program to the MTC Executive Committee on De-cember 12, 2014.34 Assuming the Executive Committee approves the program, it would formally launch in July 2015.35
III. Laying the Proper Foundation
While it is true that a well-designed and disciplined transfer pricing audit program is preferable to what trans-pired in Microsoft, BP, and Exxon Mobil, it is important to consider whether the ALAS program is being built on the proper foundation. Taxpayers might also benefit from so-phisticated analyses by trained economists, as opposed to state auditors with little or no expertise in the area of transfer pricing. For example, we have seen numerous instances when a company’s transfer pricing study has been rejected by state tax authorities without ever consulting an expert or offering any meaningful analysis of section 482 or the accompanying regulations.36 Nevertheless, it is important to ask whether the time is right for a broad-based transfer pricing effort. Specifically, will the effort achieve more prin-cipled and fair administration of the states’ tax laws regard-ing intercompany arrangements and transactions? Will it limit improper base erosion, or will it simply be yet another avenue for states to make discretionary adjustments? The ALAS program’s success in meeting those goals is contin-gent on laying the proper foundation, which can only be achieved if the states first understand the scope of their section 482 authority and establish meaningful guidance on how they intend to administer their laws within the confines of the ALAS program.
The IRS has long used transfer pricing adjustments to reallocate income among multinational corporations. Sec-tion 482 of the Internal Revenue Code grants the IRS commissioner broad discretionary powers to allocate in-come or expenses among related entities to clearly reflect
20Bucks, ‘‘Comparison Among Three Design Scenarios:
Recom-mended, Accelerated, and Contractor Focus Versions,’’ Dec. 2, 2014, at 2.
21Id. 22Id. at 7.
23Bucks, supra note 1, at 13. 24Id. at 14. 25Id. 26Id. at 10-11. 27Id. at 11-12. 28Id. at 20-21. 29Id. at 21. 30Id. 31Id. at 31.
32Amy Hamilton, ‘‘Draft Design of MTC Transfer Pricing Project
Includes Economic Consultants,’’ State Tax Notes, Oct. 13, 2014, p. 65. A business case was later incorporated into the draft design. Bucks,
supra note 1, at 2-4.
33Hamilton, ‘‘MTC Transfer Pricing Project to Include Voluntary
Disclosure Period,’’ State Tax Notes, Nov. 10, 2014, p. 314.
34Hamilton, ‘‘States Could Recoup $25 Million Annually Under
Proposed MTC Transfer Pricing Program,’’ State Tax Notes, Dec. 8, 2014, p. 527.
35Id.
36Those studies have also been challenged on the basis that the
state’s statutes are ‘‘like’’ section 482 but do not require strict adherence to the IRC and accompanying regulations.
income. The regulations under section 482 place a con-trolled taxpayer on tax parity with an unconcon-trolled taxpayer by determining the controlled taxpayer’s true taxable in-come, using an arm’s-length standard.37
Section 482’s regulations set forth numerous methods for evaluating the arm’s-length nature of intercompany transactions.38The regulations provide no particular order for the application of the enumerated transfer pricing meth-ods; however, under the ‘‘best method’’ rule, the arm’s-length result of a controlled transaction must be determined under the method that under the facts and circumstances provides the most reliable measure of an arm’s-length re-sult.39
In the federal tax arena, practitioners and taxpayers alike have become intimately familiar with section 482 and the accompanying regulations, and although disputes arise, the regime is well established. States’ administration of transfer pricing regimes is much less established and less transparent. According to the MTC, approximately 25 states and the District have enacted their own stand-alone transfer pricing statutes.40The precise number of states with express section 482-type authority is uncertain because numerous state provisions deviate significantly from the federal language.41 However, in most of those jurisdictions, the legislature has adopted section 482’s language either in whole or in part, according to the MTC.42
Even states that lack authority under their own statutes to impose transfer pricing adjustments may still be able to bring such challenges by virtue of their conformity to the IRC. For example, an Idaho transfer pricing regulation appears to rely entirely on the state’s conformity to the IRC.43On the other hand, at least one court has held that a state’s conformity to the IRC for tax computation purposes did not empower the state’s tax authority to make transfer pricing adjustments under section 482.44
Despite most states possessing some form of section 482 or type of authority, in our experience, true 482-focused audits are infrequent (although we assist clients with some such audits). In other words, states do not focus on adjusting the intercompany price to cure alleged base ero-sion; rather, alleged base erosion is typically addressed through the assertion of other challenges, including nomic nexus, forced and mandatory combination, eco-nomic substance, and business purpose adjustments. States also routinely invoke sham transaction or economic sub-stance principles to disregard some related-party transac-tions in both the separate return and combined return contexts.45 Other states have enacted addback statutes, which generally preclude taxpayers from taking deductions arising from both interest and intangible expenses paid to affiliates.46 Finally, many separate-return states have pro-vided their tax administrators with discretionary authority to compel related parties to file combined returns as a means of reallocating income and expenses.47
Indeed, even when states have used section 482-type authority, state tax authorities often assert other adjust-ments. For example, historically, the New York State De-partment of Taxation and Finance has sought to cure alleg-edly distortive arrangements by forcing combination.48 Only fairly recently have we experienced New York taking the position on audit that section 482-type adjustments ought to be used to cure distortion; interestingly, that posi-tion has been taken in ‘‘decombinaposi-tion’’ audits in which the department sought to decombine entities or deny a refund claim based on combination.49New York, not unlike other states, has no statutory or regulatory guidance addressing which adjustment, transfer pricing or combination must be given priority in circumstances when either could be ap-plied.50
Given the lack of uniformity among state laws and the divergent nature in which states have administered their section 482 (or 482-like) authority both substantively and
37Treas. reg. section 1.482-1(a)(1).
38For an overview of the various methods set forth in the Treasury
regulations for determining the arm’s-length nature of a particular transaction, see Scott L. Brandman et al., ‘‘Limitations on State Trans-fer Pricing Adjustments,’’ State Tax Notes, Dec. 13, 2010, p. 771.
39Treas. reg. section 1.482-1(c)(1).
40Bruce Fort and Lila Disque, ‘‘Possible Uniformity Project:
Ap-plying State ‘IRC Section 482’ Authority to Adjust Income and Expenses of Related Parties to Clearly Reflect Income; Summary of Existing Statutes and Regulations,’’ Feb. 22, 2013, at 2.
41Id. at 3. 42Id.
43Idaho Admin. Code r. 35.01.01.015 (2014) (providing that the
‘‘discretion granted to the secretary of the Treasury to determine or reallocate items of income or adjustments to income, deductions, expenses, credits or other subjects of taxation by the [IRC] may also be exercised by the Tax Commission’’).
44Comptroller v. Gannett Co., 356 Md. 699, 709 (1999). Following Gannett, Maryland enacted legislation explicitly granting its
comptrol-ler authority to adjust items of income or expense between related parties. See Md. Code Ann., Tax — General, section 10-109 (2014).
45See, e.g., Syms Corp. v. Commissioner of Revenue, 436 Mass. 505,
512-513 (2002) (holding that deductions arising from royalty pay-ments to a wholly owned intangible holding company were properly disallowed when the transactions were not supported by a business purpose).
46See, e.g., Conn. Gen. Stat. section 12-218c, 12-218d; Mass. Gen.
Laws ch. 63, section 31I, 31J.
47See, e.g., Wal-Mart Stores E. Inc. v. Hinton, 197 N.C. App. 30, 58
(2009) (upholding the forced combination of Wal-Mart and a captive real estate investment trust, thereby eliminating deductions arising from rental expenses).
48See, e.g., Coleco Indust. v. New York State Tax Comn., 461 N.Y.S.2d
462 (N.Y. App. Div. 1983); Campbell Sales Co. v. New York State Tax
Comn., 490 N.Y.S.2d 313 (N.Y. App. Div. 1985); In re Heidelberg Eastern Inc., DTA Nos. 806890 and 807829 (N.Y. Tax App. Trib., May
5, 1994).
49See generally, e.g., Matter of IT USA Inc., DTA Nos. 823780,
823781 (N.Y. Tax App. Trib. 2014).
50See N.Y. Tax Law section 211.5.
procedurally, it is hard to imagine how a uniform audit program such as ALAS will unfold.
IV. Additional Observations
Although the scope of the ALAS program has yet to be defined, its spectrum will draw further attention to transfer pricing and other issues regarding base erosion. At the very least, states will continue to conduct their own audits in which transfer pricing issues will arise.
A. Compliance
The forthcoming ALAS program only increases the need for taxpayers to prepare themselves for audit. In this regard, we recommend they review material intercompany transac-tions to consider the extent to which those transactransac-tions comport with section 482 principles. Because of their mag-nitude and complexity, transfer pricing audits present sig-nificant challenges to both taxpayers and the states. In that environment, taxpayers must be proactive in limiting their transfer pricing exposures. For instance, taxpayers should make sure that their intercompany transactions have been reviewed by a transfer pricing expert. Similarly, taxpayers should review their existing transfer pricing studies to en-sure that they reflect business practices; to the extent studies exist, we often find that such studies are outdated. Finally, taxpayers should not be afraid to challenge proposed trans-fer pricing adjustments, especially when the adjustments are inconsistent with the taxpayer’s own documentation or with the scope of state authority.
B. Contingent Fee Auditors
The states’ concern over the cost of the ALAS program reveals one of its flaws and leads to concerns whether tax-payers will be treated fairly on audit. For example, states will
be monitoring the revenue collected through the ALAS program closely, as they consider whether to continue fund-ing it. Similarly, the outside contractors retained by the program may have incentive to take aggressive positions on audit as they attempt to demonstrate their own worth.
There has been a considerable amount of debate regard-ing the impact of the states’ fee arrangements with outside contractors on the impartiality of their studies. In the un-claimed property area, for example, when states routinely outsource audit functions to outside consultants on a contingent-fee basis, some have questioned whether con-tractors are using dubious estimation techniques to artifi-cially increase assessments.51 Specifically, those arrange-ments have been criticized for causing contractors to be too aggressive during audit, to interpret state laws to their own advantage, and to cherry-pick audit targets based on pro-jected revenue.52
In the transfer pricing area, companies like Chainbridge are often compensated on a performance-based model, in which a contractor’s payment is essentially a function of how useful its information is on audit. Although performance-based models are not traditional contingent-fee arrangements, they arguably raise the same concerns over whether taxpayers are being treated fairly on audit. ✰
51See, e.g., Cara Griffith, ‘‘States’ No-Holds-Barred Approach to
Auditing Transfer Pricing Arrangements,’’ State Tax Notes, Feb. 13, 2012, p. 559.
52Id. (quoting Jana S. Leslie, ‘‘The Best and Worst of State
Un-claimed Property Laws,’’ Council on State Taxation (Jan. 2009)).
