Cha-CHING! States Turn to Transfer Pricing to Raise Revenue
New Multistate Tax Commission Initiative Includes Engaging Outside Economic Consulting Firms
The Multistate Tax Commission (“MTC”) unveiled a new Arm’s-Length Adjustment Service that would enable states to conduct transfer pricing audits with support from specialist economist firms. The nine states investing in the MTC program include Alabama, the District of Columbia, Florida, Georgia, Hawaii, Iowa, Kentucky, New Jersey and North Carolina. The proposed four-year charter period is expected to start shortly after MTC meetings in July 2015. This program represents a significant commitment of states’ resources in an area expected to raise substantial revenue.
All companies should consider whether states might challenge profit shifting from interstate pricing of goods, services, and intellectual property under audit.
Transfer pricing audits are of greater importance from so-called “separate reporting” states as the prices charged on interstate transactions, between related companies, drive how much tax is paid by state. Consequently, tax authorities can raise substantial tax revenue by adjusting the prices on goods, services, and royalties charged to a related company in another state. Most states also refer to the “arm’s-length standard” under the same principles of the IRS’ Section 482 transfer pricing regulations.
Many states already have transfer pricing regulations in place, but historically lacked the resources to conduct transfer pricing audits. By engaging outside economic consulting firms, state tax auditors will now have support from experienced transfer pricing practitioners. The MTC also expects to build in-house capacity from consultant training and knowledge sharing among states, including hiring a senior economist, attorney, and tax manager early in the process.
States do not require transfer pricing documentation, so many companies may not think about state transfer pricing until auditors knock on the door. Transfer pricing audits are highly facts-and-circumstance driven, so transfer pricing auditors would normally expect to assess: (1) how the business operates in each state, (2) how the industry operates, (3) financial information on an entity-by-entity basis, and (4) an economic analysis to determine whether interstate pricing is conducted on an arm’s-length basis. A typical US transfer pricing documentation report prepared for IRS purposes includes this information.
Recent State Transfer Pricing Audit Activity – a Sign of What’s to Come?
Several states have litigated transfer pricing issues over the years, but the District of Columbia has been most notable in auditing transfer pricing recently. The District of Columbia’s Office of Tax and Revenue engaged an outside consulting firm to audit several companies on interstate transfer pricing issues. Many companies had assessments ranging from $700,000 to $2.86 million in tax overturned, but BP Products settled and paid $581,600 to the Office of Tax and Revenue. Even more troubling is the consultant was paid on a contingency-fee basis, on a percentage of tax generated. Although one judge found the outside firm’s economic approach to be “worthless,” their consultant’s contract was renewed.
Based upon our assessment of discussions within the MTC, we anticipate the nine states using the service will actively engage their outside consultants in all aspects of audits, especially during the first few years of the program. MTC currently projects state reports will cost approximately $25,000 per audit in outside consulting fees. Most of the outside consulting firms that would be hired by MTC have considerable “Big-4” transfer pricing expertise, and we anticipate a more sophisticated approach to targeting companies, along with well-argued economic analyses.
What Red Flags Will Attract States’ Attention?
In our experience, transfer pricing auditors, both in the US and globally, are most often concerned about companies incurring losses. Auditor thought processes often start with “would an independent company, operating at arm’s-length, continue to incur losses year-after-year?” Companies with a large volume of intercompany transactions, whether it be inventory, services, royalties, and loans, are also another red flag for auditors. Microsoft was one company selected for audit in Washington, DC given their large volume of service transactions.
Companies unable to explain how they establish state-to-state pricing or only argue that “poor business conditions” are to blame, may be surprised when an auditor adopts an alternative perspective.
Where Does This Fit in the Big Picture?
States’ concerns over transfer pricing are a natural progression from alarm with global companies paying their “fair share” of tax on an international basis. News reports of companies shifting profits to tax havens, inversions, or intellectual property migration have piqued the interest of state tax revenue administrators. Bottom line, auditing transfer prices can be a big revenue raising tool, and state-to-state transactions are no longer immune from scrutiny.
 By contrast, unitary states generally require companies file a combined return and intercompany transactions are disregarded.
Taxable income is then allocated by a formula, normally based on sales, assets and employment  State laws usually refer to the US transfer pricing regulations under IRC §482, which reference the arm’s-length standard.
For related party transactions, companies should use the same prices they would charge an unrelated company.  Other states such as Connecticut and Pennsylvania have attended the MTC planning meetings, and other states have the option
of joining MTC transfer pricing initiatives in the future.