State Transfer Pricing Cases Show Importance of Documentation

Under Section 482 of the tax code, and associated regulations, the IRS can reallocate income and expenses among related entities to prevent tax evasion and clearly reflect income. These federal transfer pricing rules intend to promote fair taxation of transactions within multinational entities, aligning taxable income with economic realities and value creation.

Many states are authorized to adjust taxable income and apportionment among related entities to fairly reflect a taxpayer’s activity in a state. States don’t have their own explicit transfer pricing rules, so they often use Section 482 to make such adjustments. States also are empowered to use Section 482 by statutes that explicitly incorporate Section 482 and its regulations, through general conformity to the IRC, by utilizing administrative authority, or through other means.

Although state transfer pricing isn’t a new concept, we have noticed an increase in audit activity over the past several years. Several key developments help shed light on this trend and highlight the importance of intercompany agreements, robust transfer pricing analysis, and comprehensive transfer pricing documentation.

Precursor to Audits

An agency’s implementation of voluntary payment programs is one indicator of future audit activity and focus. North Carolina, New Jersey, Louisiana, and Tennessee introduced voluntary disclosure agreement programs to encourage taxpayers to come forward and report past transactions voluntarily. Louisiana also offers a managed audit program, which allows eligible corporate taxpayers to conduct self-audits on intercompany transactions under revenue department supervision.

Such programs might signal the imminence of future increased audit activity. These programs assess enhanced penalties for taxpayers that are later audited for issues within the scope of a voluntary disclosure agreement program but failed to participate in the program.

Indiana has an advance pricing agreement program, which allows taxpayers to agree with the state on the transfer price for intercompany transactions.

Recent Decisions

Multiple states have recently challenged intercompany transactions for violating arm’s-length, business purpose, or economic substance principles.

High-quality, current, and well-developed transfer pricing studies have contributed to several taxpayer victories. Conversely, state wins often reflect the absence or inadequacy of such studies. Court remedies for adjusting income can include disallowing deductions, mandating combined filing, and imposing penalties and interest.

The Indiana Tax Court found that transfer pricing studies, conducted to satisfy Section 482 requirements, demonstrated that intercompany transactions were at arm’s-length rates. The court emphasized that the studies were valid and reliable, supporting the taxpayer’s position.

A taxpayer last month settled its Louisiana Department of Revenue dispute, which originated in the state’s transfer pricing managed audit program, regarding deductions relating to intercompany transactions.

A South Carolina administrative law court determined in July that a taxpayer’s restructuring and intercompany transactions distorted taxable income, requiring related entities to file a unitary combined return. The taxpayer supported the value of transferred intangibles with a valuation study based on Section 482 regulations. However, the court questioned the study’s reliability.

Another case, Tractor Supply Co. v. South Carolina Department of Revenue, is a landmark in state transfer pricing. Generally, South Carolina’s alternative apportionment authority allows the department to require combined unitary reporting if it can prove that the standard statutory method doesn’t fairly represent the extent of a taxpayer’s business activity in the state. In line with this authority, the department outlined the factors it may consider when evaluating whether the statutory formula fairly represents a taxpayer’s in-state activity.

In Tractor Supply, the department argued that separate entity reporting didn’t fairly represent a taxpayer’s business activity in the state because the taxpayer was “shifting income” to Texas through an intercompany charge. The department asserted that the taxpayer and its affiliate operated as a unitary group and were required to file a combined unitary South Carolina return. On appeal, the court determined that the markup didn’t reflect arm’s-length value and that the taxpayer’s transfer pricing study was flawed and unreliable.

These state transfer pricing decisions prompt several key takeaways.

Intercompany agreements are critical to support the form and substance of intercompany transactions. In line with international transfer pricing principles, state tax authorities use intercompany agreements as the starting point for their review. Accordingly, these intercompany agreements must reflect the nature of the transaction and be updated as needed.

The intercompany transaction flow must be accurately captured from a financial perspective. Journal entries are insufficient; invoices must support the value of intercompany transactions. States will review bank statements to confirm payments and receipts on an intercompany basis.

Transfer pricing documentation must be maintained to support the arm’s-length nature of the intercompany transaction. In Tractor Supply, a 2001 study was provided supporting transfer pricing calculations for the 2014–2016 audit years, with a memorandum stating that there were no significant changes for that period. Although contemporaneous transfer pricing documentation for penalty protection purposes might not be required for state transfer pricing, it is good practice to update documentation every three to five years.

Transfer pricing documentation increasingly takes on a specific form and includes the 10 principal documents under tax code Section 6662. But practical documentation—such as board meetings, transfer pricing policies, and investment decisions—is needed to provide context to the intercompany transactions.

Looking Ahead

Transfer pricing remains an area of focus for states. In July, New Jersey requested quotes from qualified service providers with transfer pricing expertise to assist the Division of Taxation with corporation business tax audits.

New Jersey continues to be interested in transfer pricing despite moving away from unitary reporting to combined reporting. This drives home the broader point that transfer pricing documentation and analysis is critical to state tax compliance.

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

Author Information

Sowmya Varadharajan is leader of Crowe’s national transfer pricing practice.

Mike Santoro is a state and local tax principal with Crowe.

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