Transfer Pricing at the State Level
Transfer pricing is typically associated with international cross-border transactions of multinational companies. But in the U.S. it is also a consideration for individual states. The Multi-State Tax Commission (“MTC”) has advocated for transfer pricing documentation when applying transfer pricing concepts to state taxation. The MTC proposed a plan for state tax adoption of transfer pricing concepts well-traversed in the international tax area. Under the approved draft, which the MTC anticipates implementing over a 4-year period, the Arm’s Length Adjustment Service (“ALAS”) advisory group will provide states with training and support for transfer pricing audits. In May 2016, the MTC held an ALAS committee meeting to discuss public comments, ALAS program design, a participation agreement draft, training request status, and next steps.
The ALAS has 4 main goals: (1) improve the ability of states to identify and correct cases of taxpayer underreporting associated with related-party transactions; (2) foster dispute resolution by offering an initial voluntary disclosure opportunity, utilizing the MTC dispute resolution process, and providing litigation support to states; (3) increase audit coverage of related-party transactions; and (4) advise states on related-party transaction developments.
To achieve these objectives, ALAS is pursuing the following strategy: (1) build effective transfer pricing audit capacity through knowledge- and experience-sharing and training of MTC and state staff; (2) collaborate among MTC staff, consultants and state staff across compliance, auditing, economics and law; (3) hire and develop core MTC staff, and contract with outside experts; and (4) develop procedures to improve tax compliance for related-party transactions across state borders.
Because the MTC raised transfer pricing’s visibility and recognized that it may yield additional state revenue, it anticipated states may request documentation to support the arm’s-length nature of intercompany transactions. The following summarizes elements of a transfer pricing study.
Even though states look to § 482 of the Internal Revenue Code (“IRC”), they are not limited to federal rules, and the MTC did not pursue uniformity with the ALAS project. Because the updated MTC draft design for the ALAS program does not include a framework, will auditors follow § 482 given the lack of uniformity between the states?
If auditors do follow § 482, state documentation should equal or include the documentation requirements under Treasury Regulations § 1.6662-6 relating to transactions between persons described in § 482 and net § 482 transfer price adjustments.
Preparing state transfer pricing documentation in a similar format described under § 1.6662-6 ensures a robust and cohesive presentation of a company’s state transfer pricing position for a given fiscal year. If the intercompany transaction facts and circumstances do not change significantly from year to year, it may be sufficient to update the financial analysis annually and revise the complete study periodically (every other year or every 3 years).
Some challenges faced by auditors and preparers of state transfer pricing studies are combined reporting, add-back statutes and asserted nexus. Combined reporting results in eliminating intercompany transactions in consolidation. As such, they may be overlooked or not tested separately. Many states require combination based upon broad discretionary authority, and a disaggregation may only become visible if forced under audit or with legislative change. Preparers are required to add back certain categories of intercompany expenses—which may also be imposed on embedded royalties—in calculating taxable income, unless an exception is met. Preparers must know that certain exceptions require consideration of an arm’s-length mark-up. Lastly, asserted nexus of a related party, particularly intangible holding companies based upon economic nexus, may have significant state tax implications that are a direct result of the functions, risks and assets associated with the entities engaging in the intercompany transactions giving rise to nexus.