Transactions between related entities are common and engaged in for both business and tax purposes. Management fees, factoring fees, loans, and other intercompany transactions can be beneficial from a tax planning standpoint, provided the transactions are properly structured and supported by adequate documentation, which often includes a transfer pricing study.
Transfer pricing is the means of establishing that intercompany transactions within a group of related entities are priced at arm's length. Although related entities are obligated to use the arm's-length standard when they price a transaction internally for tax purposes, determining the transfer price is important for many reasons, including that it affects the profit realized in different parts of the group. Also, because the related entities that enter into intercompany transactions often cross geographic boundaries, multistate businesses have used intercompany transactions to lower their effective state tax rate. However, an improperly determined transfer price can result in the loss of tax benefits for the entities involved.
For more than a decade, state tax authorities have been aggressive in examining intercompany transactions to ensure that transactions are properly priced and that revenue and expenses are properly allocated to a particular jurisdiction or entity. Because of the perception that intercompany transactions can be easily abused by, for example, charging exorbitant management fees or pricing inventory too high, tax officials have targeted the validity of intercompany expense deductions as ripe for audit.
At the federal level, Internal Revenue Code section 482 grants the IRS discretionary authority to challenge intercompany transactions by readjusting items of income and deductions to more clearly reflect taxable income. Although most states have not adopted IRC section 482 (section 482 does not normally apply to states by virtue of regular conformity), numerous state statutes grant similar powers to their tax officials.
States have not, however, been particularly successful in challenging the arm’s-length pricing of intercompany transactions. This may be because of the complexity of the legal concepts involved (only a few states have auditors trained in the fundamentals of section 482) or because of the theory that adoption of combined reporting eliminates the ability of related entities to engage in questionable transfer pricing practices (combined reporting arguably reduces the ability to artificially shift income).
Regardless, the Multistate Tax Commission is embarking on a project to help states conduct transfer pricing audits by providing training for state tax officials or by easier access to outside economic experts. The project, entitled the Arm’s-Length Adjustment Service, is still being developed and is scheduled to begin in July, but corporate taxpayers should take notice now. The result could be a significant increase in the number of state transfer pricing audits.