Tax Analysts Blog

Transfer Pricing Is All the Rage -- in the States

Posted on Feb 17, 2016

For most of my 29 years in the tax business, transfer pricing was considered an international issue: Japanese corporations selling televisions to their American subsidiaries, with the IRS claiming they were charging too much; and American companies leasing patents held by related companies in Luxemburg and the IRS claiming they were paying too much. For decades, virtually every multinational conglomerate was involved in transfer pricing audits or litigation. The sheer enormity of the problem led to advance pricing agreements and later to the base erosion and profit-shifting project. Until relatively recently, the term "transfer pricing" was rarely used in the state tax world. My colleague Cara Griffith wrote a series of terrific articles on state transfer pricing in 2011 and 2012, detailing the aggressiveness of the states in the wake of the recession. That was the start of state interest in transfer pricing outside the legislative debates over combined reporting.

Over the past several months, however, this state interest in transfer pricing has grown to one of the most talked-about topics in state taxation. During my interview with Stephen Kranz of McDermott Will & Emery for Tax Notes Live, he predicted that transfer pricing would be the most important issue in the coming year. The Multistate Tax Commission is forging ahead with its transfer pricing program, and the newly added Marshall Stranberg will enhance that effort. As my colleague Amy Hamilton reported, PwC is predicting a lot more state scrutiny of intercompany transactions. The Deloitte Tax LLP SALT practice leaders, in the pages of State Tax Notes, predicted the same. State tax officials, such as Alabama Deputy Revenue Commissioner Joe Garrett Jr., have said that their states are going to be concentrating on transfer pricing and intercompany transactions.

I must confess, I am surprised at the sudden interest in transfer pricing in the state tax world. Don't get me wrong, transfer pricing has a lot to do with all that ails the state corporate income tax -- those 50 million corporations that exist only in the desk drawer of a lawyer in Delaware are proof of that -- but this kind of state transfer pricing has been around since the beginning of the corporate income tax.

Moreover, of the 44 states that tax corporate income, 24 of them, as well as the District of Columbia, have adopted combined reporting. In the combined reporting states, transfer pricing should be a minor problem, since all of the intercompany transactions are basically eliminated and the ability to shift profits to low- or no-tax states is very limited. By the way, this is precisely why big business does not like combined reporting.

Even in separate accounting states, there have been steps taken to address the transfer pricing problem: Seven states have enacted addback provisions that prevent deductions for payments to related passive investment companies. So it seems that transfer pricing involving intangibles is a problem in about 13 states. That said, transfer pricing involving non-intangibles is a problem in every separate accounting state -- and it always has been. So why the new and intense interest in transfer pricing at the state level?

Here's what I think. States continue to be under budgetary pressures. Many, including separate accounting states, are broke. Raising taxes remains politically difficult. When states are broke and cannot raise taxes, they do two things: They resort to gimmicks like gambling and cigarette taxes, and they step up their enforcement and collection activity. I think the state governments are performing transfer pricing audits to recoup some of the tax revenue lost from real or perceived income shifting. Transfer pricing audits are politically attractive ways to collect revenue. The states can go after individuals, but there is no money, and people get annoyed easily. Transfer pricing audits involve multistate companies, and there isn't much sympathy for big companies skirting the tax laws.

So we may be on the cusp of a great battle over transfer pricing. I find this very exciting for revenue departments, private sector lawyers, accountants, and of course tax journalists. I doubt it will be good for corporations. But as someone who used to do section 482 work internationally, I predict this will be a difficult journey for the MTC and the revenue departments. The IRS had a terrible record fighting real and perceived transfer pricing abuses. When proving arm's-length pricing, the side that can spend the most on good lawyers, accountants, and economists almost always wins.

A version of this post appeared in State Tax Notes.

 

Read Comments (1)

AhsanFeb 24, 2016

I do agree with your understanding, now this become a big issue, OECD working
should be appreciated. we cannot stop TP but minimize it with the help of
qualified IRS officials or through BEPS, OECD, FATCA.

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