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Inside Deloitte State transfer pricing: Are you prepared for increased scrutiny?

by Michael Bryan, Andrew Fisher, Conrad Krol, and Karen Notz, Deloitte Tax LLP

Summer 2015

State Transfer Pricing:Are You Prepared for Increased Scrutiny?

by Michael Bryan, Andrew Fisher, Conrad Krol, and Karen NotzBusinesses operating in more than one state or country

often do so through multiple corporate entities. That neces-sitates intercompany transfer pricing arrangements that areincreasingly scrutinized by the states. Many states challengethe pricing of intercompany transactions through statutesand regulations that are similar to or that adopt InternalRevenue Code section 482. States may also negate the effectof intercompany transactions through, for example, the useof discretionary powers to adjust income, statutes requiringthe addback of some intercompany payments, or the asser-tion of nexus principles for entities not physically present inthe state.

Many states believe there is significant additional revenuethat could be collected by challenging intercompany trans-actions. Some states have engaged outside consultants tobetter equip their revenue authorities for this purpose. Also,the Multistate Tax Commission is pursuing an initiativedirected at developing a multistate transfer pricing service,known as the Arm’s-Length Adjustment Service (ALAS)program, that, if implemented, would support state revenueauthorities in their review of intercompany transactions.While the ALAS program remains under consideration,state interest in the proposed service, and in the relatedtransfer pricing training sessions offered by the commission,suggests that states desire improved transfer pricing auditcapability. Accordingly, taxpayers need to be prepared todefend state audits or assessments arising from an adjust-ment to intercompany charges.

In this article, we provide an overview of intercompanytransfer pricing arrangements and related state tax consid-erations, summarize the latest developments involving theMTC’s ALAS project, and suggest actions that taxpayersmay wish to consider in developing exam-ready transferpricing documentation.

I. Legal Entity PlanningDespite a U.S. economy that is rebounding from the

Great Recession, nearly half of the states expect a budget

Karen NotzConrad Krol

Michael Bryan Andrew Fisher

Michael Bryan is a director in Deloitte Tax LLP’s Wash-ington National Tax Multistate practice. Andrew Fisher is adirector in Deloitte’s National Transfer Pricing practice.Conrad Krol is a director and Karen Notz is a senior man-ager in Deloitte’s National Multistate Tax practice.

In this edition of Inside Deloitte, the authors provide anoverview of intercompany transfer pricing arrangementsand related state tax considerations, summarize the latestdevelopments involving the Multistate Tax Commission’sArm’s-Length Adjustment Service project, and suggest ac-tions that taxpayers may wish to consider in developingexam-ready transfer pricing documentation.

This article does not constitute tax, legal, or other advicefrom Deloitte, which assumes no responsibility regardingassessing or advising the reader about tax, legal, or otherconsequences arising from the reader’s particular situation.The authors thank Fred Paladino, Michael Paxton, andSnowden Rives for their review of this article.

Copyright 2015 Deloitte Development LLC.All rights reserved.

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deficit for the upcoming fiscal year.1 Faced with these short-falls, some states have looked for tax revenue sources that arepalatable to the resident constituents. As demonstratedthrough the number of states that within the past decadehave legislatively moved to a single sales factor for stateapportionment purposes, many state policymakers view thestate corporate income tax as a revenue base that can grow atthe cost of businesses not substantially located in their state.

Of the 44 states that impose a corporate income tax,roughly half do not mandate that a taxpayer calculate itsstate tax liability on a combined or consolidated basis. Inthese states where the default method requires a taxpayer todetermine its state tax liability on a separate legal entitybasis, policymakers have focused their attention on curbingactual and perceived tax planning structures that result in acorporate tax base that in their view does not fairly measurethe taxpayer’s activities in the state.

State income tax savings can occur when income shiftsfrom a taxpayer operating in a separate filing state to arelated entity that conducts its business activities in a differ-ent state (for example, with a lower income tax rate). Stateincome tax savings may also occur when income shifts to ataxpayer with a lower apportionment factor percentage in aseparate filing state. In some instances, even when stateincome tax rates are equivalent, income shifting may pro-duce a reduction in an affiliated group’s overall state taxliability due to the implications of combined and separatefiling methods. Further, intercompany transactions mayfacilitate the use of state net operating losses and tax credits.

Transactions between entities within a corporate groupcan and should occur for a number of commercially justifiedreasons, including the acquisition of inventory, the use ofintangibles, the need for short- or long-term financing, andthe need for centrally provided services.

In the (now seemingly distant) past, a common arrange-ment was for a separate legal entity to hold an intangibleasset used by related corporations. This state tax planninginvolved the separate legal entity being domiciled in a statesuch as Delaware, Nevada, or a combined return state whereintercompany royalty income was favorably treated or elimi-nated. The separate legal entity would charge the relatedcorporations a royalty for use of the intangible asset. Theintercompany royalty payment reduced the state taxableincome of the related operating corporations in separatereturn states. Over the years, states have, in general, negatedmost of the favorable state income tax results associated withthis type of legal entity organization, notwithstanding thatthose structures were implemented for business reasons,including the protection of intangible property.

Additional tax planning approaches involving intercom-pany transactions to reduce the tax base in separate return

states may include a parent corporation doing businesssolely in a combined return state that pushes down debt to asubsidiary conducting business in separate return states.Thepayment of interest on the intercompany debt is eliminatedin the parent corporation’s state tax return but is deductedin the subsidiary’s state tax returns.

Other common tax structures consist of intercompanycharges for services, an approach often implemented toachieve economic efficiencies through operational stream-lining. For example, a parent corporation or a shared ser-vices company may charge intercompany management feesto related corporations for the performance of centralizedmanagement and administrative functions.

Another common transaction structure is when a dedi-cated entity is responsible for selection and procurement ofinventory that is then sold to a retail network operated by aseparate legal entity.

Whether a legal entity structure hasresulted in actual or unintentional taxplanning, state policymakers have beenactive in closing perceived tax loopholes.

Although these corporate structures may be purposefullyentered into in part to achieve income tax savings, as notedpreviously, these tax planning opportunities involve trans-actions that a related group of corporations may enter intofor common business reasons, such as legally protectingintangible property (IP) from lawsuits, sharing the costs ofacquisition debt, realizing economic efficiencies througheliminating functional redundancies, and increasing prod-uct margins through centralized purchasing. Many tax-payers may be able to achieve state income tax savings (or,conversely, additional tax costs) through a combination ofimplementing common business practices, applying astate’s method of determining a corporation’s income taxliability, and the choice of legal entity organization.

II. State Response to Legal Entity Planning

Whether a legal entity structure has resulted in actual orunintentional tax planning, state policymakers have beenactive in closing perceived tax loopholes. One method ofattack has been to implement mandatory unitary combinedreporting. Within the past decade, seven states have adoptedcombined reporting. Many state tax authorities assert thatthe move to combined reporting increases the tax basebecause the filing method negates the ability to use inter-company charges to reduce a taxpayer’s profits. However,there are several factors that could decrease a taxpayer’s taxbase through combined reporting. One factor involves theability of a taxpayer to include loss companies in its tax basethat would otherwise be excluded. Another factor involvesthe ability of a taxpayer to include related corporations that

1Christina A. Cassidy, ‘‘Nearly Half of States Expect to ConfrontBig Budget Gaps,’’ U.S. News & World Report, May 9, 2015.

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dilute the state apportionment factor and, as such, reducethe portion of the taxpayer’s taxable income apportioned tothe state.

These factors could be why several states that consideredcombined reporting during the past decade decided tocontinue imposing corporate income tax on a separate re-turn basis. State legislatures have generally turned to otherpolicies to attack perceived legal structure planning. Themost common approach has been to require the addback ofsome intercompany royalty payments, interest expense de-ductions, or management fees paid by related members.

A. IRC Section 482 and State AuditsState tax authorities conduct tax audits that scrutinize

intercompany transactions, potentially resulting in adjust-ments to the calculation of state taxable income. Regardlessof a state’s audit authority used to adjust a taxpayer’s statetaxable income, the state typically relies primarily on thearm’s-length principle (as discussed in IRC section 482) tosupport their adjustments.

IRC section 482 requires taxpayers engaged in transac-tions with related parties to do so on a basis consistent withdealings between unrelated parties (that is, consistent withthe arm’s-length principle). When dealings between relatedparties are considered not to be arm’s length, IRC section482 permits an adjustment to the value of those transactionsto bring the pricing in line with the arm’s-length price, witha result and recalculation of the taxable income of theaffected taxpayer. Specifically, IRC section 482 provides thatthe U.S. Treasury has the power to ‘‘distribute, apportion, orallocate gross income, deductions, credits, or allowances’’between two or more organizations that are owned or con-trolled directly or indirectly by the same interests to preventtax evasion or to clearly reflect the income of any of thoseorganizations, trades, or businesses.2

A transaction between related parties will be consideredarm’s length if the results are the same as those for uncon-trolled taxpayers engaged in the same transaction under thesame circumstances.3 To support an arm’s-length transac-tion, taxpayers rely on a transfer pricing analysis groundedin accepted economic principles. A review of independent,comparable uncontrolled transactions is at the heart of atransfer pricing analysis. The analysis may consider inde-pendent transaction values (prices), margins (gross or net),or resulting profits.4

Most states may try to use IRC section 482-type powersto assign income from transactions with related parties;however, the discretionary authority of the state taxingadministrators varies from state to state. Some states adoptIRC section 482 by specific reference or by using federaltaxable income as the starting point in determining state

taxable income. Other states provide broad discretionarypowers under an IRC section 482-type statute. However,some states limit the discretionary authority to circum-stances in which transactions between related parties havenot been conducted at arm’s length. Further, most stateseither have explicitly adopted the Uniform Division ofIncome for Tax Purposes Act statute on alternative appor-tionment or have a similar rule that allows the state admin-istrative tax authority to impose alternative apportionmentformulas if the standard formula does not fairly representthe taxpayer’s activities in the state.

The following is a discussion of the common methodsemployed by states to address the intercompany transactionsthat states perceive as improper income shifting. Thesemethods often, but not always, incorporate IRC section 482principles in order to scrutinize the intercompany transac-tions.

B. Expense Addback StatutesNearly two dozen states require some sort of intercom-

pany expense disallowance or expense addback. The report-ing requirements of intercompany expense adjustment stat-utes vary by state, but all statutes have similar characteristics.

Pennsylvania recently enacted an intercompany expenseaddback statute. For tax years beginning after December 31,2014, taxpayers generally may not deduct intangible orinterest expenses and costs paid or accrued to an affiliatedentity.5 However, if the affiliated entity is subject to tax onthe corresponding intangible or interest item in any U.S.state or possession, a tax credit against the taxpayer’s Penn-sylvania liability is provided.6 Also, Pennsylvania’s statutecontains exceptions to the required expense addback ifspecific conditions are met, including:

• the intercompany transaction is with an affiliated en-tity domiciled in a foreign nation that has a compre-hensive tax treaty with the United States;7

• the intercompany transaction is with an affiliated en-tity that directly or indirectly paid or accrued intan-gible or interest expenses to an unrelated party;8 or

• the intercompany transaction did not have as theprincipal purpose the avoidance of Pennsylvania taxand was done at arm’s-length rates and terms.9

Thus, the ability for a taxpayer to support a valid businesspurpose for the intercompany intangible or interest chargeexists, and that the charge was made on arm’s-length termsis important to meeting a valid exception to the Pennsylva-nia addback statute.

2IRC section 482.3Treas. reg. section 1.482-1(b)(1).4Treas. reg. section 1.482-3.

572 Pa. Stat. Ann. section 7401(3)(t)(1).6Id.772 Pa. Stat. Ann. section 7401(3)(t)(3).872 Pa. Stat. Ann. section 7401(3)(t)(4).972 Pa. Stat. Ann. section 7401(3)(t)(2). Note that in addition to

the specific expense addback requirement, Pennsylvania may deny adeduction related to a fraudulent or sham transaction. 72 Pa. Stat.Ann. section 7401(3)(t)(1).

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North Carolina also requires a corporation to add backdirect and indirect royalty payments received by relatedmembers for use of intangible property in the state.10 NorthCarolina has also enacted a broad intercompany addbackstatute that requires a corporation to add payments to orcharges by a parent, subsidiary, or affiliated corporation inexcess of fair compensation in all intercompany transactionsof any kind.11 A regulation provides that IRC section 482standards are used to determine whether or not transactionsbetween members of an affiliated group were made at fairmarket value.12 The state regulation explains that the exis-tence of a transfer pricing study is not by itself sufficient toestablish that a transaction was made at FMV.13 Rather, theNorth Carolina Department of Revenue is required to con-sider all facts and circumstances relative to the transactionsand apply federal or state case law developed under IRCsection 482 and its regulations to determine whether thetransactions were made at FMV.14

Thus, although North Carolina’s addback statute en-compasses more than intercompany intangible and interestexpenses, both the Pennsylvania and North Carolina ex-pense addback requirement exceptions anticipate that thetaxpayer will have a valid transfer pricing analysis to supporta position to deduct intercompany intangible and interestexpenses.15

Intercompany expense disallowance or expense addbackrequirements are relatively new tax rules and, as such, thereare few taxpayer challenges to the application of the statutesthat have resulted in a published judicial decision. However,a recent example highlighting the need to review the excep-tions provided by a state in its addback statute arose withinWendy’s International Inc. v. Virginia Department of Taxa-tion. In Wendy’s, the taxpayer successfully defended its in-terpretation of one of the safe harbor provisions in Virginia’sintercompany intangible expense addback statute.16 Vir-ginia requires the addback of some intangible expenses andcosts but allows an exception to the addback requirementwhen the related member derives at least one-third of itsgross revenue from the licensing of intangible property toparties that are not related members, and the transactiongiving rise to the intercompany expenses was made at rates

and terms comparable to rates and terms agreed to withunrelated parties for the licensing of intangible property.17

The taxpayer in Wendy’s was a fast-food restaurant fran-chiser (Wendy’s) that licensed trademarks and trade namesthrough a disregarded limited liability company that wasformed by a Wendy’s-owned captive insurance company.LLC licensed to Wendy’s the right to use the trademarks andtrade names owned by LLC at a royalty of 3 percent ofWendy’s gross sales. Under the legal agreement, Wendy’sgranted sublicenses to its franchisees’ restaurants to use thetrademarks and trade names and its operating systems for 4percent of the gross sales of the franchisee’s restaurant.Wendy’s filed a refund claim for the addback of the royaltiespaid to LLC under the position that Wendy’s qualified forthe safe harbor provision because LLC derived at leastone-third of its gross revenue from the licensing of intan-gible property to unrelated parties.18 The department ar-gued that the safe harbor provision did not apply becauseLLC had to directly license the trademarks and trade namesto the franchisees instead of indirectly through Wendy’s.19

The court disagreed and, applying principles of statutoryconstruction, reasoned that no direct connection betweenthe related member and the unrelated member is requiredfor the safe harbor provision to apply.20 Thus, Wendy’scould deduct the royalties paid to LLC because LLC derivedat least one-third of its gross revenue from unrelated fran-chisees, albeit indirectly through Wendy’s, and the Wendy’sroyalties paid to LLC were made at comparable rates andterms as the license agreements with the unrelated members(franchisees).21

C. NexusNexus is an area that has seen important developments in

recent years. In Quill, the U.S. Supreme Court concludedthat physical presence in the jurisdiction is not required toestablish the necessary connection under the due processclause alone. Instead, there only needs to be some definitelink between the taxpayer and the state.22 In Quill, in thecontext of sales and use taxation, the Supreme Court heldthat substantial nexus for purposes of the commerce clauseexists only if a corporation has a nontrivial physical presencein a state.23 States have taken various positions on whether‘‘physical presence’’ is also a requirement in the context of

10N.C. Gen. Stat. sections 105-130.5(a)(14), 105-130.7A(a).11N.C. Gen. Stat. section 105-130.5(a)(9).1217 N.C. Admin. Code 5F.0301(a).1317 N.C. Admin. Code 5F.0301(c).1417 N.C. Admin. Code 5F.0301(a)-(b).15N.C. Gen. Stat. section 105-130.5A(a)-(b) also provides the

North Carolina DOR broad discretion to adjust the net income of acorporation by adjusting intercompany transactions or requiring afiling of a combined tax report if the intercompany transactions lackeconomic substance or are not at FMV.

16Wendy’s Int’l Inc. v. Va. Dep’t of Taxation, 84 Va. Cir. 398, 400(2012).

17Va. Code Ann. section 58.1-402(B)(8)(a).18Wendy’s, 84 Va. Cir. 398-399 (2012).19Id.20Id. at 400.21Virginia legislatively changed the law as a result of Wendy’s and

did so retroactively. HB 5001, CH 1, 2014 Acts of Assembly 5.11(language only) section 3-5.11 Intangible Holding Company Add-back.

22Quill Corp. v. North Dakota, 504 U.S. 298 (1992).23Id. at 309 (holding that the presence of licensed software copied

on floppy diskettes and provided to customers within the taxing statewas insufficient to satisfy the due process clause’s physical presencerequirement).

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net-income-based taxes for purposes of establishing sub-stantial nexus. This has resulted in another commonmethod used by states to address income shifting intercom-pany transactions — namely, the state’s assertion of aneconomic presence nexus theory based on the exploitationof a state’s marketplace for profit. In recent years, severalstates, including California, Colorado, Connecticut, Michi-gan, New York, Ohio, Tennessee, and Washington, haveadopted a ‘‘bright-line’’ receipts factor presence standard inwhich a taxpayer is deemed to establish nexus for purposesof a state income tax if the taxpayer’s gross receipts from thestate’s marketplace exceed an established threshold.24 Underthis standard, nexus is created regardless of whether thetaxpayer has a physical presence in that state.

While these concepts have broader applications, as ap-plied to legal entity restructuring, states have successfullyattacked intangible property holding company structuressimilar to that in Geoffrey Inc. v. South Carolina Tax Com-mission.25 In Geoffrey, the taxpayer’s parent company trans-ferred IP to an out-of-state intangible property holdingcompany subsidiary, which then licensed the IP back to theparent in exchange for a royalty. The court found that thelicensing of IP to the parent in the state and receipt ofincome from the licensing created nexus for the intangibleproperty holding company without physical presence.26

ConAgra Brands Inc. v. Comptroller of the Treasury is oneof the most recent decisions to assert nexus over an intan-gible licensing company.27 In this Maryland Tax Courtdecision, the taxpayer, ConAgra Brands Inc., was created tohold the intangible property including trademarks that werepreviously held by its parent company and other affiliatedsubsidiaries. ConAgra Brands licensed the trademarks backto its parent and other subsidiaries in return for royaltyincome. This allowed ConAgra Brands’ affiliated subsidiar-ies with nexus in Maryland to have a royalty deduction ontheir Maryland corporate income tax returns. ConAgraBrands also licensed the trademarks to third-party corpora-tions and was engaged in activity beyond the mere licensingof intangibles. All profits were effectively transferred back to

its parent company by ‘‘annual payments called ‘cost ofcapital’ payments and through other internal financing ar-rangements.’’28

In its opinion, the court wrote that a ‘‘subsidiary musthave economic substance as a separate entity from its parentto avoid nexus and taxation.’’29 The court determined thatConAgra Brands was required to file in Maryland because itcould not have functioned as a corporate entity without thesupport services it received from the corporate affiliate.30

Among other findings, the court determined that the func-tional source of ConAgra Brands’ income was the ideas anddiscoveries generated by the corporate parent and that Con-Agra Brands relied on the corporate parent’s personnel,office space, and corporate services.31 These determinationsled the court to conclude that ConAgra Brands’ income isproduced from the parent’s business in Maryland, whichestablishes nexus sufficient to justify taxation.32

Indiana is another state where the tax authority appearsto follow a broad interpretation of substantial nexus. TheIndiana Tax Court held in 2013 that the corporate incometax uses a physical presence standard for establishingnexus.33 The Indiana DOR, however, reasoned in 2014 thatroyalties earned by a Delaware intangible holding companythrough licensing agreements with two Indiana affiliatesthat allowed those affiliates the right to use the IP in con-nection with the manufacture or sale of goods in the stateestablished a business situs in the state. In asserting that thelicensing agreements allowed the Delaware intangible hold-ing company to exploit its IP in Indiana, the DOR deter-mined that the state could subject the economic benefit, theroyalty payments, to Indiana’s corporate income tax. In itsdecision, the department relied on the sales factor sourcingrules to determine where the income-producing activityoccurred and concluded that these activities did not occur inDelaware, where the IP is managed, but in Indiana, wherethe royalties are earned when the goods are manufacturedand sold.34

24Cal. Rev. & Tax. Code section 23101; Col. Rev. Stat. section39-22-301(1)(d); Colo. Code Regs. section 39-22-301.1; Conn. Gen.Stat. section 12-216a(a); Mich. Comp. Laws section 206.621(1); N.Y.Tax Law section 209.1.(a) and (b); Ohio Rev. Code Ann. section5751.01(H) and (I), and Commercial Activity Tax Information Re-lease CT 2005-02 (Ohio Dept. of Taxn., Sept. 2005); Tenn. CodeAnn. section 67-4-2004 (as added by HB 0644, 2015 Leg., 109th Gen.Assemb., Reg. Sess., Tenn. May 20, 2015; effective for tax yearsbeginning on or after January 1, 2016); Wash. Rev. Code sections82.04.066 and 82.04.067, and Wash. Admin. Code section 458-20-19405.

25Geoffrey Inc. v. S.C.Tax Comm’n, 313 S.C. 15 (1993), cert. denied,114 U.S. 550 (1993).

26313 S.C. at 23.27ConAgra Brands Inc. v. Comptroller of the Treasury, No. 09-IN-

OO-0150 (Md. Tax Ct., Feb. 24, 2015).

28Id. at 10-11.29Id. at 12.30Id. at 11-12.31Id. at 11.32Id. at 12. In contrast to the Maryland opinion, the West Virginia

Supreme Court of Appeals held on the same facts in Griffith v. ConAgraBrands Inc., 229 W.Va. 190 (W.Va. 2012), that the licensing activitiesof ConAgra Brands did not satisfy the ‘‘purposeful direction’’ conditionunder the due process clause and ConAgra Brands did not meet the‘‘significant economic presence’’ requirement under the commerceclause, and as such, did not have substantial nexus with West Virginia.229 W.Va. at 200.

33United Parcel Service v. Dep’t of Revenue, 995 N.E.2d 20, 23 (Ind.Tax Ct. 2013).

34Indiana Department of Revenue, Letter of Findings No. 02-20140072 (Jun. 25, 2014).

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D. Sham Transaction/Economic SubstanceThe federal tax judicial doctrines of sham transaction and

economic substance have become more prevalent for attack-ing intercompany transactions. Courts have long appliedthese doctrines in determining, for federal income tax pur-poses, whether a corporation should be respected as a sepa-rate taxable entity or disregarded because the legal entitylacks economic activities and exists as a vehicle to achieve taxsavings.35 The application of the sham transaction, eco-nomic substance, and similar tax avoidance doctrines by thestates has resulted in differing interpretations of the mean-ing of these principles. These doctrines have also sometimesbeen used interchangeably to deny an affiliate the benefit ofan intercompany deduction. For example, these doctrineshave been used to justify disregarding the legal entity receiv-ing the payment, denying the expense amount paid to thetax avoidance entity, or effectively eliminating the intercom-pany expense by requiring the filing of a combined orconsolidated return. The following is an example of howtwo states have reached different conclusions regarding ap-plication of the sham transaction or economic substancedoctrine to intercompany royalty deductions.

The federal tax judicial doctrines ofsham transaction and economicsubstance have become more prevalentfor attacking intercompany transactions.

In Sherwin-Williams Co. v. Commissioner of Revenue, theSupreme Judicial Court of Massachusetts allowed as a de-duction the royalties paid by the parent corporation,Sherwin-Williams, to related subsidiaries for the use of tradenames, trademarks, and service marks (marks).36 The com-missioner of revenue had denied the deduction because thetransfer of the marks to newly formed subsidiaries and thenthe licensing back of those marks to the operating corpora-tions was a sham and could be disregarded under the shamtransaction doctrine. In applying the doctrine in the contextof a reorganization, the court explained that a taxpayer candemonstrate that the transaction is real if the ‘‘reorganiza-tion results in ‘a viable business entity,’ that is one which is‘formed for a substantial business purpose or actually en-gages in substantive business activity.’’’37 The court furtherstated that ‘‘whether a transaction that results in tax benefitsis real, such that it ought to be respected for taxing purposes,depends on whether it has had practical economic effects

beyond the creation of those tax benefits.’’38 Further, thecourt wrote, ‘‘tax motivation is irrelevant where a businessreorganization results in the creation of a viable businessentity engaged in substantive business activity rather than ina ‘bald and mischievous fiction.’’’39 The court cited thesubsidiaries’ entry into genuine obligations with unrelatedthird parties for use of the marks, the subsidiaries’ invest-ment of the royalties with third parties, and the substantialsums of liabilities paid to third parties and the parentcorporation to maintain, manage, and defend the marks asevidence of economic substance or substantive businessactivity.40 Thus, the court concluded that the state ‘‘erredwhen it found that the transfer and the licensing backtransactions between Sherwin-Williams and its subsidiarieswere without economic substance and therefore a sham.’’41

In contrast, the New York State Tax Appeals Tribunaldecided, on essentially the same facts, that the Sherwin-Williams intangible holding companies and the resultinglicensing of the marks had no economic substance or validbusiness purpose because the transactions were ‘‘inherentlyillogical.’’42 The tribunal determined that Sherwin-Williams acted as the subsidiaries’ service provider for themarks, which demonstrated that the functions of Sherwin-Williams had not changed after the formation of the intan-gible holding companies and thus, the only obvious benefitof the transaction was to successfully avoid taxes.43 Thetribunal also found persuasive the argument that ‘‘therewould be serious economic risk in any business arrangementwhich separates the responsibility for marks and brandmanagement from those in a company who work with thebranded products on a daily basis and have actual knowl-edge of the brands, customer requirements, customer expec-tations and corporate capabilities.’’44 Further, the tribunalconcluded that it was proper to require Sherwin-Williamsand the subsidiaries to file a combined report because inaddition to the lack of economic substance, the indepen-dent, professional appraisal report valued the marks toohigh, and a subsequent transfer pricing report was flawedbecause the set of comparables excluded companies withsignificant intangibles.45

35See Moline Properties Inc. v. Commissioner, 319 U.S. 436 (1943);National Investors Corp. v. Hoey, 144 F.2d 466 (1944); Shaw Construc-tion Co. v. Commissioner, 35 T.C. 1102 (1961); William B. Strong v.Commissioner, 66 T.C. 12 (1976), aff’d without publishing opinion, 553F.2d 94 (2d Cir. 1977).

36Sherwin-Williams Co. v. Commissioner of Revenue, 778 N.E.2d504, 508 (Mass. 2002).

37Id. at 515.

38Id. at 516.39Id. at 518-519.40Id. at 517-518.41Id. at 508. Also in this decision, the commissioner alternatively

asserted that the royalty payments should be eliminated because theywere not made at arm’s length and distorted the actual income of thetaxpayer. The court, however, was satisfied that the royalty paymentswere arm’s-length transactions based on an independent, professionalappraisal report that valued the marks and recommended a range ofroyalty rates. Id. at 508, 521-522.

42Matter of Sherwin-Williams Co., DTA No. 816712 (N.Y. TaxApp. Trib., June 5, 2003).

43Id. at 170.44Id. at 168-169.45Id. at 172, 177.

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E. Transfer Pricing Scrutiny

An early case addressing the use of IRC section 482principles to assess state intercompany transactions wasMatter of Tropicana Products Sales Inc.46 In that case, theNew York State Tax Appeals Tribunal concluded that thetaxpayer failed to rebut the presumption of distortion result-ing from substantial intercorporate transactions.47 Theintercorporate transactions were not governed by an inter-company agreement, and the transfer pricing study pro-vided was prepared three years after the taxpayer received itsnotice of deficiency.48 Also, the tribunal determined that thecomparable set of companies used in the transfer pricingstudy was flawed.49 In rendering its decision, the tribunalexplained that under Treas. reg. section 1.482-1(d)(1),‘‘comparability of transactions and circumstances must beevaluated considering all factors which could affect prices orprofits including functions, contractual terms, risks, eco-nomic conditions and property or services.’’50 Further, the‘‘uncontrolled transaction need not be identical, only suffi-ciently similar so that it can render a reliable measure of anarm’s length result.’’51 The state analyzed the comparablesused in the report and determined there were enough ma-terial differences between the comparable companies andthe taxpayer that the difference affected the measure of anarm’s-length rate.52 Some of the material differences in-cluded the use of a start-up company, a purchasing co-opthat may not be maximizing profits, and the selection ofcompanies conducting business in different geographic re-gions.53

In contrast, the taxpayer in Hallmark Marketing Corp.was able to rebut the presumption of distortion by demon-strating that the intercompany transactions were at arm’slength.54 The New York State Tax Appeals Tribunal deter-mined the transfer pricing report was ‘‘sound and thor-oughly prepared’’ and consistent with the IRC section 482regulations.55 In its decision, the tribunal noted that there isflexibility in choosing the method under the section 482regulations.56 In selecting the method, ‘‘the two primaryfactors to be considered are the degree of comparability

between the controlled transaction and any uncontrolledcomparables, and the quality of the data and assumptionsused in the analysis.’’57

The Indiana DOR recently required the forced combi-nation of an Indiana corporate income taxpayer that in-cluded a disregarded distribution entity and a parent corpo-ration.58 The distribution entity made wholesale sales ofconsumer products produced by the parent corporation’smanufacturing subsidiaries. Indiana pointed to several factsas evidence that the taxpayer’s business was not an ‘‘inde-pendent operation,’’ including that the transfer pricingstudy was prepared before the taxpayer’s business structurewas established. Also, the transfer pricing study supportedan intercompany rate equal to the prices paid 30 yearsearlier. As such, the transfer pricing study could not supportthe taxpayer’s current business activities.

III. Recent State Transfer Pricing Audit ActivitiesSome jurisdictions, including the District of Columbia

and New Jersey, engaged third-party contractors to providetransfer pricing analyses. Regarding the District, taxpayershave challenged, and continue to challenge, the District’smethods, with several cases under appeal. As these methodshave come under greater scrutiny, state interest in forming aunified transfer pricing audit program has increased.

IV. MTC InitiativeIn a meeting of the MTC Executive Committee on May

9, 2013, Michael Bryan, while in his position as the directorof the New Jersey Division of Taxation, requested that theMTC consider the creation of a dedicated transfer pricingaudit program. Bryan reasoned that such a program wouldallow states to address their concerns about domestic andinternational transfer pricing noncompliance by supple-menting state audit staff with seasoned transfer pricingprofessionals centralized within the MTC Joint Audit Pro-gram. Bryan also asserted that addressing transfer pricingissues within the program could result in a more consistentand defensible work product and that MTC personnelcould provide end-stage audit assistance, including appealsand litigation support. Bryan cautioned that if an MTCtransfer pricing audit program was not created, a possiblealternative would be for states to cooperate and form coali-tions using existing information sharing agreements to ad-dress the potential noncompliance in this area.

On March 13, 2014, the MTC announced its plan todevelop the ALAS project, a state transfer pricing auditprogram that would enable participating states to poolresources to secure economic expertise to support arm’s-length issues on audit, administrative appeals, and litiga-tion. An advisory group was formed to lay out a conceptual

46Matter of Tropicana Products Sales Inc., DTA No. 815253 (N.Y.Tax App. Trib., June 12, 2000).

47Id. at 70.48Id. at 70-71.49Id. at 84.50Id. at 76.51Id.52Id. at 77-86.53Id. See Matter of Lowe’s Home Centers, DTA No. 818411 (N.Y.

Tax App. Trib., Sept. 30, 2004) for a similar determination in whichthe taxpayer could not rebut the presumption of distortion because ofa flawed transfer pricing study.

54Matter of Hallmark Marketing Corp., DTA No. 819956 (N.Y. TaxApp. Trib., Jan. 26, 2006).

55Id. at 81.56Id. at 76-77.

57Id. at 76.58Indiana DOR, Letter of Findings No. 02-20130641 (Feb. 25,

2015).

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framework of the project.59 In the meetings and teleconfer-ences that followed, there were discussions regarding therelevance of the project to different state tax regimes. Duringthe December 12, 2014, meeting of the MTC ExecutiveCommittee, Dan Bucks,60 the ALAS project facilitator,indicated that the project would be important in analyzingtransfer pricing studies in separate company reportingstates; analyses would not be limited to U.S. borders; andstates could be better positioned to analyze and adjust thepricing in cross-border transactions.

States have not typically challenged international related-party transactions on transfer pricing grounds. However, asinternational tax structures come under increasing scrutinyfrom various authorities at the international level (for ex-ample, the base erosion and profit-shifting project of theOECD), some states have taken action.61 For instance,several states have in recent years begun enacting ‘‘tax haven’’provisions that bring into a combined report the tax base ofa foreign entity doing business in some overseas jurisdic-tions.62 Some states have also increased challenges to U.S.-foreign intercompany debt structures that otherwise passedIRS muster.

In addition to extending the use of ALAS to internationaltransfer pricing issues, Bucks proposed at the December 12meeting that ALAS resources could also be used in conduct-ing unitary relationship analyses to determine the membersof a combined reporting group. Previous discussions havealso highlighted the potential uses of transfer pricing as acomponent of state intercompany addback statutes, wheretransfer pricing could be used to identify indirect or embed-ded royalties.

On May 7, 2015, the executive committee passed amotion to accept the final design of ALAS. The design hadbeen submitted to 48 states during February 2015. TheMTC received responses from 31 states, many decliningparticipation in the program. Six states have committed toALAS: Alabama, Iowa, Kentucky, New Jersey, North Caro-lina, and Pennsylvania. The final design of ALAS includesthe following core concepts:

• Transfer Pricing Analysis. When there is a taxpayer-provided transfer pricing report, the MTC would hireor contract with economists for economic review ofthe report, and the MTC would use its auditors toperform noneconomic analysis of the report, such aschecking for calculation errors or the absence of abusiness purpose and selecting comparables.

• Training. Train auditors in related areas, includinghow to identify issues, what information to obtainfrom taxpayers, how to obtain that information, andhow to conduct noneconomic analysis noted above.63

• Information Exchange. ALAS would provide for taxauthority exchange of taxpayer information related totransfer pricing issues and sharing of information forconducting joint audits.

• Case Resolution and Litigation Support. These ac-tivities include assisting states on strategies for appealsand litigation and providing expert witnesses in litiga-tion and other similar activities. The design also antici-pates a voluntary disclosure period to be implementedduring the developmental stage, which may occurduring July to December 2016.

• Optional Joint Audits. The plan envisions ALAS as acomponent of the MTC’s existing joint audit pro-gram.

Although the final program design of ALAS has beenaccepted by the executive committee, it remains to be seenwhether the MTC will be able to attract enough states tofund the program toward implementation.64 The potentialcost of ALAS is estimated at $2 million per year. However,Bucks asserted that the preliminary estimate of a $25 mil-lion annual benefit from ALAS was conservative. MTCDeputy Executive Director Greg Matson noted in his pre-sentation to the executive committee that several states saidthey ‘‘couldn’t commit at this time.’’ However, Matson saidthose states described themselves as ‘‘very interested’’ andsaid they ‘‘want to keep an eye on’’ the program. The MTCintends the final design to be submitted to the full MTC forratification during its annual meeting in Spokane, Washing-ton, on July 29.

V. Audit PreparationAlthough the full scope and implications of the MTC

transfer pricing program are unclear at this time, it is evidentfrom the ALAS development meetings that some states havea growing interest in cooperating to more effectively addressinterstate and international transfer pricing issues. Also,

59The advisory group was made up of representatives from Ala-bama, the District of Columbia, Florida, Georgia, Hawaii, Iowa,Kentucky, New Jersey, and North Carolina.

60Bucks was formerly the MTC executive director and Montanadirector of revenue.

61National Grid USA Service Co. v. Commissioner, No. ATB 2014-630, Mass. App. Tax Bd. (2014) (decision upholding assessmentsdenying a domestic taxpayer’s interest deductions for payments underdeferred subscription agreements with foreign entities because thoseagreements did not qualify as true debt in the absence of an uncondi-tional obligation to repay).

62See, e.g., Alaska Stat. section 43.20.145(a)(5); D.C. Code Ann.section 47-1810.07(a)(2)(F)(i); Mont. Code Ann. section 15-31-322(f ); Or. Rev. Stat. section 317.715(2); R.I. Stat. 44-11-4.1(d); W.Va. Code section 11-24-13f(a)(7).

63The MTC has already begun training efforts. On March 31 andApril 1, staff from the taxing authorities in Alabama, Connecticut,Florida, Georgia, Iowa, Kentucky, Louisiana, New Jersey, North Caro-lina, and Pennsylvania attended a transfer pricing training programconducted by the MTC in North Carolina.

64On May 19, 2015, Greg Matson said on a webcast that the‘‘MTC won’t launch the program until at least nine or ten states signon as charter — and paying — members.’’

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state taxing authorities are likely to continue to conducttransfer pricing audits and may explore various approachesto enhance their transfer pricing audit capabilities as dem-onstrated by the MTC-sponsored transfer pricing programsalready underway. In the interim, taxpayers may wish toprepare exam-ready transfer pricing documentation ad-dressing state-specific concerns. Taxpayers may also reviewexisting transfer pricing studies to determine whether anupdate is advisable, given changes to the taxpayer’s businessactivities or whether those studies need to be adapted to takeinto account state laws, such as statutory expense addbackrules and penalty provisions. If a transfer pricing study hasnever been completed, a taxpayer should strongly considerobtaining a study, even if the report is prepared post-transaction. The study may be useful in an audit or indetermining potential issues with current filing positions.Taxpayers should also follow through with corporate for-malities associated with intercompany arrangements.

VI. Conclusion

Taxpayers often operate through multiple legal entitiesthat enter into intercompany transactions, requiring a de-termination of the proper pricing for those transactions. Asstates increase their intercompany transaction audit activi-ties, prudent taxpayers will be proactive in reviewing thebusiness operations of their affiliates to verify the existenceof economic substance, including the ability of an affiliate tooperate as a viable business entity in fulfillment of its busi-ness purpose. Diligent taxpayers will also revisit the docu-mentation to support intercompany pricing, including therelevancy of the transfer pricing report to the taxpayer’scurrent business operations and the comparables relied onto determine the arm’s-length rates. These activities mayhelp taxpayers address concerns in advance of state auditactivities that focus on intercompany transactions. ✰

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