State Transfer Pricing Defense Needs Deep Section 482 Analysis

Multinational corporations have long battled the IRS and other nations’ taxing authorities over their transfer pricing arrangements.

But transfer pricing examinations and disputes at the state level can be even more challenging due to a lack of consistency and transparency, particularly in states that require entities conducting a unitary business to file separate state income tax returns.

This leaves many corporations in a precarious position, unsure how to defend very defensible transfer pricing arrangements. However, companies have defeated state transfer pricing examinations and disputes, and there are important takeaways from these taxpayer wins.

Being Proactive

Not all state laws allow state tax departments to make transfer pricing adjustments when a taxpayer’s transfer pricing falls within the parameters of Section 482 Treasury Regulations. If a company can establish that its transfer pricing is consistent with those regulations, the state tax department may not have power to make adjustments, though that won’t always stop it from trying.

In such cases, the taxpayer only needs to prove that its transfer pricing aligns with the Section 482 regulations by providing a transfer pricing study or, even better, proof the IRS approved the taxpayer’s transfer pricing.

The taxpayer should do this before providing information and documents about its intercompany transactions and agreements. An auditor likely will demand more information, but the taxpayer should dispute the legal issue of the department’s authority at the outset when possible.

Intercompany transactions and agreements data, when provided, should be explained to state auditors, who generally aren’t experienced in transfer pricing examinations. For instance, many states have informal policies for audits of related-party transactions, and rarely undertake the requisite analysis in the Section 482 regulations to identify the best way to determine whether intercompany transactions are at arm’s length.

The overwhelming trend among states that have pursued a transfer pricing analysis has been to rely on the comparable profits method, but this often isn’t the best way to determine arm’s-length transactions.

Taxpayers must explain their transfer pricing policies, the method of analysis, and any significant intercompany transactions. Those with significant transfer pricing experience can educate auditors on how arm’s-length determinations are made and avoid unnecessary controversy.

When to Litigate

Most transfer pricing audits can be resolved without litigation because the adjustments come down to a subjective disagreement between the taxpayer and state about operating margins of in-state taxpayers. Sometimes, however, taxpayers should prepare for the possibility of litigation and appeals.

For instance, South Carolina since 2015 has aggressively adjusted the income of unitary businesses operating in the state by forcibly combining unitary businesses. While many taxpayers initially settled these audits, the state revenue department acknowledged it lacked resources to litigate all the audits that had been disputed.

Here, there was a clear legal dispute—South Carolina was using its alternative apportionment authority to adjust the income tax base of in-state taxpayers by combining them with out-of-state unitary businesses. At least a dozen taxpayers filed protests at the Administrative Law Court.

Similarly, the Louisiana Department of Revenue has consistently used the comparable profits method in its audits to the exclusion of other potentially better methods. Taxpayers are challenging the department’s perfunctory use of this method. Resolving these unique legal questions will position the state and taxpayers to better resolve future audits.

Due diligence in this respect is paramount. Taxpayers should consider whether state litigation can implicate any agreements they’ve reached with the IRS or other foreign governments.

Knowing the timeline of other taxpayers’ protests can be crucial, even if it’s not always transparent. A taxpayer with one fact pattern that is first in line may negatively affect other taxpayers. Understanding the facts of first-in-line cases could lead some taxpayers to settle their cases or push to fast-track their own case to prioritize its specific facts.

Advocacy for Change

To get ahead of costly and lengthy transfer pricing disputes, interested parties should consider advocating for a law change identifying the bounds of state transfer pricing adjustments.

For example, some state tax departments use transfer pricing adjustments to transform the state’s statutory separate company reporting system into a combined reporting system. The South Carolina Department of Revenue was one of these. Legislative outreach proved successful in South Carolina last month when Gov. Henry McMaster (R) signed into law Act No. 113, which restricted the Department of Revenue’s ability to require combined reporting under the state’s separate company reporting system.

Reining in a state tax transfer pricing dispute can be challenging. It is critical to identify any limitations on the tax department’s ability to make adjustments at the outset of the audit and hold the auditor to those limitations.

Taxpayers also must lean on state courts and legislatures to establish principles—if not clear rules—governing state transfer pricing.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.