1. What’s up with State Transfer Pricing?
SEATA 2017
New Orleans

2. Agenda What is Transfer Pricing? Overview of Federal Transfer Pricing
Overview of State Transfer Pricing
Update on State Cooperation
the Multistate Tax Commission ALAS SITAS Project … and beyond
OECD BEPS Initiative

3. What is Transfer Pricing?

4. What is Transfer Pricing?
Refers to the mechanism used to establish the arm’s-length price of transactions between related entities for goods, intangible assets, services, loans and management fees
Designed to prevent tax avoidance by requiring pricing equivalent to prices available with an uncontrolled party
Non-arm’s length transactions can impact the clear reflection of income across taxing jurisdictions (i.e., internationally, in states where income is reported on a separate or partial combination basis)
Tax evasion or avoidance generally not a pre-requisite for application of § 482 adjustment

5. Are Intercompany Transactions an Issue for Business?
On a major accounting firm’s web seminar within the last year, the following polling question was asked of nearly 3,000 participants, “Is your enterprise involved in significant intercompany transactions?”

6. Are Intercompany Prices Up-to-Date?
On another major accounting firm’s web seminar the following polling question was asked of roughly 2,000 participants, “Where your company has domestic intercompany transactions, how often do you review and update the intercompany prices?”

7. Overview of Federal Transfer Pricing Principles

8. Transfer Pricing Authority – Federal Background
Federal landscape
Codified under IRC § 482
Extensive regulations, detailed methodologies
Developed body of judicial decisions
Disciplined procedures for obtaining advance approval for transfer pricing
Transactions between affiliated entities can be adjusted to “arm’s length” if necessary to prevent evasion of taxes or to clearly reflect the income of such businesses
Statutory language
In any case of two or more organizations, trades, or businesses owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. . .

9. Transfer Pricing Authority – Federal Background
Concepts
Existence of Controlled Transactions
Arms length standard
IRC 6662 Contemporaneous Documentation
Best Method Rule (e.g., resale price method, cost-plus method, comparable profits method (CPM)) - Treas. Reg (c)(1)
Intercompany services: probable benefits test - Treas. Reg (b)(2)(i)
Advance Pricing Agreements

10. What is the remedy?
If the IRS determines that the transfer price of the transaction did not meet the requirements of § 482, it can:
Propose settlement with taxpayer
Adjust the transfer price to reflect the proper cost
Make corollary adjustment
Impose penalties for gross understatement of income
Penalties can amount to 20% or 40% of the difference between the tax paid and the tax owed depending on whether certain thresholds are met

11. State Transfer Pricing Overview

12. Separate Company State Problem and Perspective
Complex tax strategies shift income from separate company states to combined return jurisdictions via related-party transactions reducing liabilities in separate company states and not impacting combination states
States estimate $100s millions lost revenue annually
More complex than 80s/90s intangible holding company and related structures
Lack of expertise and/or enforcement at the state level
Separate company states should accept transfer pricing responsibilities and administer with competence and reasonableness
Transfer pricing is the other side of the combined reporting issue

13. Combined Reporting Map = SEATA

14. Shifting Income
Several types of intercompany transaction can result in the “shifting” of state income tax liabilities
The transfer and licensing of intangible assets
The purchase and resale of tangible goods
Providing and charging for common services
Intercompany financing arrangements
Factoring accounts receivables
Utilizing “embedded royalties”

15. Retailer with Purchasing Company
Parent
Purchasing Company
Retailer / Taxpayer
$$$$
Widgets $$
Management
fee
Retailer sells goods with small mark up and breaks even on its tax return after paying substantial management fee to Parent
Purchasing sells goods to Retailer at a substantial mark up and reports a majority of the Group’s taxable income
Parent reports substantial taxable income despite having little in the way of property or employees
Taxpayer’s transfer pricing study reflects the fact that Purchasing and Parent own the Group’s intangibles

16. Manufacturer with Sales Company
Parent
Manufacturing
Sales Co
$$$$
Widgets $
Sales Co sells goods with small mark up and breaks even on its tax return
Parent, located in a combined return state, sells goods to Sales at a substantial mark up and reports a majority of the Group’s taxable income
Manufacturer sells goods to Parent with small mark up and breaks even on its tax return
Taxpayer’s transfer pricing study reflects the fact that Parent owns the Group’s intangibles

17. State Adjustments State transfer pricing landscape varies: Used for –
Combination
Expense/Income adjustments or reattribution
Adjustments to international pricing that IRS “missed”
Many states have statutes that adopt or are substantially similar to § 482
States may or may not incorporate the federal regulations promulgated under § 482
Is that important?
Nearly every state adopts some statutory regime to adjust transfer prices of intercompany transactions
Some states rely on general conformity to IRC
Notable states that do not have statutory regime: Delaware, New Mexico, Pennsylvania

18. State Transfer Pricing Adjustment Authority
Example of “express” § 482 adoption (Alabama, Ala. Code § A-17)
(a) In any case of two or more organizations, trades, or businesses owned or controlled directly or indirectly by the same interests, the Commissioner of the Alabama Department of Revenue may distribute, apportion, or allocate gross income, deductions, credits, or allowances, if the Commissioner determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of Alabama income taxes or to clearly reflect the income of any such organization, trade, or business.
(f) The Commissioner shall exercise such authority in a manner consistent with this act and, to the extent applicable, 26 U.S.C. Section and the rulings and regulations issued thereunder.
See also Maryland, Md. Code Ann. Tax-Gen. § ; Arkansas, Ark. Code Ann. §

19. Recent Cases Rent-A-Center Indiana Rent-A-Center South Carolina
See’s Candy Utah
Taxpayer wins
Department could not force combination under “§ 482-like authority”
Departments of Revenue held to IRS standards
Transfer pricing studies found to be persuasive and the Department did not show it was flawed
Department must do more than argue it fails the smell test

20. Multistate Tax Commission ALAS SITAS Project and Beyond

21. Arm’s-Length Adjustment Service (“ALAS”) Project
Perceived Need and Program Development
The director of the New Jersey Division of Taxation approached the MTC in about setting up a program
States recognized that there are significant issues related to transfer pricing at the state level
Most states lack the expertise, resources, and flexibility to staff such a function themselves
In December 2013, the Executive Committee authorizes MTC executive director to explore interest among states
Project facilitator for a one-year design project hired in March 2014
Advisory Group of states supporting the design project formed by May 2014
ALAS project design approved 2015
Insufficient number of states committed to launch program
ALAS replaced with less formal SITAS project 2016 which still serves to promote and facilitate state transfer pricing cooperation

22. Arm’s-Length Adjustment Service (“ALAS”) Project Background
Design
Open and transparent
State of the art knowledge from states and experts
Executive management perspective: fitting pieces together
Long-term resource for several contexts & states
Program Features/Elements
Interrelated service elements, all mutually supportive
Training
Analysis of Transfer Pricing Studies
State Capacity Building—Beyond Training
Optional Joint Audits (through Joint Audit Program)
Early voluntary disclosure program
Taxpayers and states will be encouraged to use the Commission’s existing alternative dispute resolution process to resolve issues consistently between a taxpayer and multiple states
“Advanced Pricing Agreements” through existing ADR process

23. State Intercompany Transaction Advisory Service (“SITAS”) and Beyond
Now functioning as informal MTC vehicle to facilitate state cooperation collaboration
Encourages ad hoc bilateral / multi lateral cooperation among states to address transfer pricing and other related party transactions issues
States working amongst them selves to address issues

24. SITAS Project — Commentary and Takeaways
Where is it going?
Is it necessary and/or beneficial?
Will it work?
Challenges in implementation and operation?

25. BEPS – International Action Plan
Base erosion and profit shifting (“BEPS) -globally deployed description for tax planning strategies that rely on mismatches and gaps that exist between the tax rules of different jurisdictions.
Organization for Economic Cooperation and Development (“OECD”) is implementing a plan (approved by the G20) which seeks to identify standardized international tax rules to address BEPS.
The BEPS Action Plan “aims to ensure that profits are taxed where economic activities generating the profits are performed and where value is created.” (Source: OECD Action Plan)
Three Core Principles
Substance - align taxation to value creation
Coherence - avoid “double non-taxation”
Transparency - visibility to global information

26. BEPS Actions 9 and 10 - Transfer Pricing
Overview
Actions 9 & 10, in combination with Action 8, comprise the transfer pricing recommendations
They are designed to ensure that profit is realized in accordance to economic substance
Key Points
Action 8 – Intangibles: Purpose is to ensure that profit is aligned to value creation
Strict economic substance requirements for attribution of IP driven profits
Action 9 – TP Aspects of Risk & Capital: Ensures that profit does not accrue to entities solely based on contractually assumed risks or capital
Action 10 – High Risk Transactions: Addresses other high-risk transactions that may be subject to “recharacterization”
Action 10 addresses “low value” services
Services can be charged only if a benefit inures to the recipient

27. OECD BEPS Project – State Implications
Proceeding toward global uniform standards – are the states aligned?
Arm’s length standard still prevails
Will states respect federal and international transactional analyses?
Global mechanisms available for avoiding “double taxation” (e.g., competent authority) - will states develop a mechanism of their own?
Do apportionment methodologies (e.g., market sourcing and single sales factor) distort true jurisdictional profit attribution?
vs. international concepts for PE (i.e., nexus) and profit attribution
Does BEPS renew interest in worldwide combined reporting?
Focus on tax haven legislation?