The White House and Republican congressional leadership released an outline this week to guide forthcoming legislation on federal tax reform. The states conform to the federal tax laws to varying degrees and the extent to which they will adopt any federal changes is uncertain. This memorandum outlines some of the key areas—individual taxation, general business taxation and international taxation— with which the states will be concerned as details continue to unfold.
Favorable Guidance from the New Jersey Tax Court on the ‘Unreasonable’ Exception to the Related-Party Intangible Expense Add-back
In a recent decision, the New Jersey Tax Court provided some long-awaited guidance on the “unreasonable” exception to the state’s related-party intangible expense add-back provision. In BMC Software, Inc v. Div. of Taxation, No 000403-2012 (2017), the Tax Court held that payments made by a subsidiary to its parent for a software distribution license were intangible expenses that were subject to the add-back provision, but that the statutory exception for “unreasonable” adjustments applied so that the subsidiary was able to deduct the expenses in computing its Corporation Business Tax (CBT). The court first determined that the expense was an intangible expense and not the sale of tangible personal property between the entities because the contract specifically called the fee a royalty, the parent reported the income as royalty income and the parent retained full ownership of the intellectual property rights indicating that no sale had taken place. Thus, the court determined that the intangible expense add-back provision did apply. The most interesting aspect of this case, however, was the court’s application of the “unreasonable” exception to the intangible expense add-back provision because that had not yet been addressed by the courts in New Jersey.
The Tax Court established two critical points with respect to the add-back of related-party intangible expenses: first, that the “unreasonable” exception does not require a showing that the related-party recipient paid CBT on the income from the taxpayer; and secondly, that a showing that the related-party transaction was “substantively equivalent” to a transaction with an unrelated party is sufficient evidence that the add-back is “unreasonable.” (more…)
- Multistate Tax Commission (MTC) transfer pricing program moving forward in some fashion;
- Priority includes information sharing among participating states (and possibly their third party vendors) on transfer pricing issues. Because a formal agreement was found necessary, the scope of the information shared is presumed to include taxpayer specific information; and
- States currently have significant inventory of transfer pricing audits that they admit they do not have the expertise to properly examine or defend in a protest.
The inaugural meeting (via conference call) of the Multistate Tax Commission’s Committee (Committee) addressing transfer pricing issues (ALAS) took place on April 7, 2016, and was certainly interesting. A predecessor Working Group had created an extensive plan that is intended to be implemented by the Committee over 4 years. The plan initially anticipated that approximately 10 states (at least) would agree to fund the cost of the multi-year program, but meeting that goal has not materialized. Instead, the Committee is moving forward hoping to add more states (or limit services provided) as the plan progresses. The anticipated program has multiple parts such as training, additional MTC staff resources and multistate transfer pricing audit and litigation support for participating states.
Ten states identified themselves on the call – only Pennsylvania was new to the process; the rest of the states on the call had all been involved in the predecessor Working Group. Also on the call was Eric Cook, co-founder of Chainbridge, the company that is currently involved in the controversial transfer pricing approach adopted by the District of Columbia (and previously by some other states). To no one’s surprise, all of the states agreed that Joe Garrett, Deputy Co-Commissioner of Revenue of Alabama, should be Chair of the Committee (he was the chair of the Working Group as well). The group will have monthly calls which are open for the public to listen in on. (more…)
District of Columbia’s Transfer Pricing Enforcement Program and Combined Reporting Regime: Taking Two Bites of the Same Apple
In his recent article, “A Cursory Analysis of the Impact of Combined Reporting in the District”, Dr. Eric Cook claims that the District of Columbia’s (D.C. or the District) newly implemented combined reporting tax regime is an effective means of increasing tax revenue from corporate taxpayers, but it will have little overlap with D.C.’s ongoing federal-style section 482 tax enforcement. Dr. Cook is chief executive officer of Chainbridge Software LLC, whose company’s product and services have been utilized by the District to analyze corporations’ inter-company transactions and enforce arm’s length transfer pricing principles. Combined reporting, (i.e., formulary apportionment, as it is known in international tax circles) and the arm’s length standard, are effectively polar opposites in the treatment of inter-company taxation. It is inappropriate for the District (and other taxing jurisdictions) to simultaneously pursue both. To do so seriously risks overtaxing District business taxpayers and questions the coherence of the District’s tax regime.
Both combined reporting and 482 adjustments have had a renaissance in the past decade. Several tax jurisdictions, including the District, enacted new combined reporting requirements to increase tax revenue and combat perceived tax planning by businesses. At the same time, some tax jurisdictions, once again including the District, have stepped up audit changes based on use of transfer pricing adjustment authority. This change is due in part to new availability of third-party consultants and the interest in the issue by the Multistate Tax Commission (MTC). States have engaged consultants, such as Chainbridge, to augment state capabilities in the transfer pricing area. At the request of some states, the MTC is hoping to launch its Arm’s Length Audit Services (ALAS) program. States thus have increasing external resources available for transfer-pricing audits.
A similar discussion regarding how to address inter-company income shifting is occurring at the international level, but with a fundamentally important different conclusion. The national governments of the Organization for Economic Cooperation and Development (OECD) and the G-20 are preparing to complete (on a more or less consensual basis) their Base Erosion and Profit Shifting action plan. This plan will reject formulary apportionment as a means of evaluating and taxing inter-company transactions. Thus, in the international context, formulary apportionment and transfer pricing adjustment authority are not seen as complementary, but instead are seen as mutually exclusive alternatives. The history of formulary apportionment in international context sheds light on why states make a mistake when they seek to use both combined reporting and transfer pricing adjustments.
A combined reporting basis of taxation seeks to treat the members of a consolidated group as a single entity, consolidating financial accounts of the member entities and allocating a portion of the consolidated income to the taxing jurisdiction based on some formula or one or more apportionment factors. Under the arm’s length approach, individual entities of a consolidated group within a single jurisdiction are treated (generally) as stand-alone entities and taxed according to the arm’s length value (the value that would be realized by independent, [...]
Deputy Executive Director Greg Matson (a nice guy at heart) announced this week that the Multistate Tax Commission (MTC) has hired its first transfer pricing training consultant and is scheduled to begin training state auditors. The training, titled “Identifying Related Party Issues in Corporate Tax Audits” will be hosted by the North Carolina Department of Revenue from March 31 to April 1, 2015 in Raleigh, North Carolina. While the much anticipated Arm’s Length Adjustment Service (ALAS, discussed in more depth in our February 6, 2015 blog post, available here) is still pending approval of the MTC Executive Committee and ratification at the annual meeting this summer, it has not stopped MTC officials from moving forward with training state auditors on transfer pricing. This training (and any subsequent training offered before the annual meeting) will be conducted as part of the MTC’s “regular training” schedule (and is not directly tied to the ALAS program since authority to train for that program has not vested). Nonetheless, Executive Director Joe Huddleston made it clear in a recent letter to the states that “[t]his course will preview the training to be provided through the Arm’s-Length Adjustment Service.”
The kickoff training session at the end of this month will be conducted by former Internal Revenue Service Office of Chief Counsel senior economic advisor, Ednaldo Silva. He is the founder of RoyaltyStat LLC, one of the transfer pricing consulting firms that is being considered by the MTC to provide their services for the ALAS. During yesterday’s teleconference of the ALAS Advisory Group, Matson and Huddleston were optimistic that additional training sessions would be offered by the MTC before the ALAS is finalized. It remains to be seen whether this training will be offered by Silva or another participant from the October 2014 Advisory Group meeting that has submitted a bid to be the contract firm for the ALAS. Because these trainings are a fundamental threshold step to commencing ALAS audits (projected to begin December 2015), they provide a strong signal that the MTC is optimistic that they will have sufficient support from the states to continue the ALAS program.
In a letter distributed to 46 states and Washington, D.C. in February 2015, the MTC officially solicited state commitments to the ALAS program. States were given until the end of March 2015 to respond. By the terms of the ALAS proposal, the MTC will need a commitment from at least seven states for the program to move forward. MTC officials announced at yesterday’s Advisory Group teleconference that the current count is zero (with one state declining). While there is still time to respond, several revenue department officials voiced concern about making a commitment without more detailed estimates of costs. Others voiced uncertainty about the ability to enter into a contract for such a long period under state law (the program requests that each state commit to four years). While there was no significant undertone of opposition to [...]
This past December, the Multistate Tax Commission’s (MTC) transfer pricing advisory committee and its project facilitator Dan Bucks recommended what it calls the “preliminary design” approach for a proposed Arm’s Length Adjustment Services (ALAS) program. While still subject to approval, states already anticipate that the program will increase their state transfer pricing revenues.
The MTC ALAS is an attempt to bring to state governments a comprehensive and coordinated program to address income shifting and the loss of state tax revenues, much along the lines of what the United States and other foreign governments have been trying to do, most recently in their Base Erosion and Profit Shifting (BEPS) initiative. The ALAS program is intended to address both interstate income shifting, which is never addressed at the federal level, and international income shifting, which the MTC believes is massively under-audited at the federal level. According to some estimates, state revenue losses from transfer pricing total as high as $20 billion a year.
Fundamental to the preliminary design will be the hiring of a mix of MTC in-house and contract consulting expertise for advanced economic and technical analysis of taxpayer-provided transfer pricing studies, including providing alternative recommendations to taxpayer positions. This approach (in contrast to a fully outsourced or in-house approach) recognizes the highly specialized and interdisciplinary nature of transfer pricing analysis, and the need to both quickly and effectively address and resolve immediate cases, as well as to build the capabilities and capacity (through training, information exchange, process improvements, etc.) to support state transfer pricing needs for the long-term.
Set to be voted on by the MTC’s Executive Committee at its May meeting, the ALAS program would kick-off in July 2015 with the hiring of an in-house tax manager, followed shortly thereafter with the engagement of one or more private economic consulting firms and an in-house senior economist by the end of the year. The program would begin transfer pricing analyses by December 2015, with the completion of up to 18 joint economic studies by the end of 2017.
The focus of the initial stages of the ALAS approach will be on reviewing and analyzing the taxpayer’s existing transfer pricing study—questioning, critiquing and (re)-computing the taxpayer’s results– rather than attempting to re-create the transfer price whole cloth. The effect is likely to produce a more rigorous, sophisticated and traditional analysis, one that paradoxically is likely to corroborate those taxpayer studies that are both thorough and orthodox in their approach, but at the same time pose a serious challenge to those that are not.
To the extent taxpayers don’t have formal documentation, they would be well-served to get it, or at least develop external third party benchmarks to corroborate their cross-border intercompany pricing.
The MTC’s proposed ALAS program is quite ambitious, not only in terms of its operational goals and timing, but also in its conception. Preliminary or not, the programs’ combination of outside expert consultants with coordinated state resources, should cause taxpayers to reexamine the “designs” of their state transfer pricing [...]
Beleaguered D.C. Taxpayers Achieve Another Success in Ongoing Challenges to the Methodology Used in the District’s Transfer Pricing Audit Program
On Friday, November 14, 2014, an administrative law judge (ALJ) issued three identical orders granting the taxpayer’s motion for summary judgment in Hess v. OTR, Shell v. OTR and ExxonMobil v. OTR. In these orders, the ALJ determined that based on an early ruling that the challenged methodology was fatally flawed, the Office of Tax and Revenue was barred from re-litigating the issue in the current cases under the doctrine of non-mutual collateral estoppel.
Transfer Pricing Implications
The transfer pricing litigation in D.C. has been a frustrating road for taxpayers because the flaws in the methodology OTR applied have been apparent from the outset. The first case to be litigated was Microsoft v. OTR, OAH Case. No. 2010-OTR-00012 (May 1, 2012). In this case, an ALJ ruled that the methodology the District used was fatally flawed because the methodology failed to (i) separate controlled from uncontrolled transactions and (ii) individually analyze different product lines and different functions. As a result, the ALJ concluded that the analysis was flawed, arbitrary and unreasonable. OTR initially appealed the Microsoft order to the D.C. Court of Appeals, only to withdraw shortly after by filing a motion to dismiss its own petition for review.
When Microsoft was decided in 2012, it appeared that the faulty transfer pricing methods used by the District had been permanently debunked. Nevertheless, OTR renewed the contract for the business performing the transfer pricing audits and did not materially modify the assessment methods. As a result, taxpayers continued receiving assessments from the OTR based on the same methodology previously ruled invalid in Microsoft. At least 10 taxpayers have challenged these assessments post-Microsoft, and the orders issued Friday are the first of these challenges to be resolved by the Office of Administrative Hearings (OAH).
The taxpayers in the Hess/Shell/ExxonMobil cases all challenged the substantive validity of the assessment methodology and argued that the Microsoft decision should be controlling. OTR asserted that the doctrine of non-mutual collateral estoppel did not apply to the government and, even if it did, the elements were not met in this case. The ALJ disagreed with OTR’s analysis and found “the failure to apply [non-mutual collateral estoppel] would allow [DC] to keep issuing proposed assessments to taxpayers using the same flawed Chainbridge analysis, with the hope that some taxpayers won’t have the wherewithal to challenge the assessment and will find it economically advantageous to simply pay rather than fight.”
The three orders issued on Friday should provide a definitive signal to OTR that the method is flawed as a matter of law and cannot be validly used to assess D.C. taxpayers going forward. These decisions are essentially decisions on the merits for the pending cases and, assuming no appeal is filed, D.C. should face sanctions if it continues to pursue assessments using the methodology at issue in these cases.
Perhaps more importantly than the narrow (but important) transfer pricing issue in these decisions, OAH has made is clear that non-mutual collateral estoppel can be applied against OTR [...]
With both Halloween and the Multistate Tax Commission (MTC) Income Tax Audit selection nearing, taxpayers should prepare themselves for the possibility of being spooked in the near future. On Thursday, October 30, from 2-4 pm EST, the MTC Audit Committee—including representatives from the 22 states participating in the upcoming round of joint income tax audits—will be holding a teleconference that will begin with a public comment period. Because of the inevitable disclosure of confidential taxpayer information, the bulk of this meeting—including selecting the various companies to audit—will take place during the second half of the agenda and be closed to the general public. Just because a company has completed an audit in the past does not mean this season will be all treats. The authors have noticed that companies previously audited by the MTC can remain on the list of targets and are often repeat selections.
The MTC audit process is not without its share of traps for the unwary. First and foremost is the effort a taxpayer must expend in managing a multistate audit. Issues such as differing statute of limitations, the effects of federal Revenue Agent’s Reports (RAR) and net operating loss (NOL) differences on limitations periods, timing of protests, and tax confidentiality become of heightened importance when one auditor is reviewing a taxpayer for multiple states. Audited taxpayers should also keep in mind that the MTC does not issue the actual deficiency notices – these must come from the states. As a result there may be certain areas such as credits or refunds that the MTC does not review and must be raised directly with a participating state.
On the substantive side, a primary area of inquiry of an MTC audit has been and is likely to continue to be inter-company transactions. Historically MTC audits have taken a variety of approaches to disallow a taxpayer’s intercompany structure, including collapsing separate affiliates, applying the sham transaction doctrine, or using aggressive addback concepts. Another similar concern for taxpayers audited by the MTC is the increased likelihood of transfer pricing issues being raised. This comes in the wake of the creation of the MTC Arm’s-Length Adjustment Service (ALAS) this summer, led by former Montana Department of Revenue Director Dan Bucks. The group recently held a transfer pricing summit at which it designed the MTC services to include third-party economic consultants at every stage. The MTC transfer pricing services are expected to be implemented in mid-2015—just in time for companies selected for an MTC Income Tax Audit to be the test subjects. Notably, of the nine states committing seed money to the development of a multistate transfer pricing audit service, five (Alabama, Hawaii, Kentucky, New Jersey and the District of Columbia) are participating in the MTC Income Tax Joint Audit Program. It is not clear whether the two MTC-sponsored audit programs will be intertwined; however, the option was proposed this past summer and remains a possibility as we approach the upcoming audit selections.
Finally, it remains to [...]
On October 6, 2014, the Multistate Tax Commission (MTC) held the first day of a two-day meeting intended to educate state revenue authorities on corporate income tax issues surrounding intercompany transactions, and further refine a path forward for states interested in collaborating on audit and compliance strategies. This first day focused entirely on presentations by specialists in transfer pricing and related intercompany transaction issues. Two important themes and one blatant omission regarding future enforcement emerged from the first day: (1) suggestions for increased disclosure and substantiation requirements; (2) safe harbor options and (3) a lack of discussion of how to prevent the risk of double taxation.
Taxpayers should be particularly concerned with the stress placed by the specialists on increased disclosure and substantiation requirements. Most of the specialists emphasized the importance of getting information into the hands of revenue authorities. Several suggested adding questions to the tax return itself such as “does the taxpayer use intangible property owned by an affiliate?” These questions would be used to identify potential audit targets and focus audit inquiries. Separately – but in a similar vein – several specialists suggested that taxpayers be required to create contemporaneous documentation substantiating their intercompany pricing at the state level. An example provided was the Organisation for Economic Co-operation and Development proposal that a taxpayer provide a country-by-country analysis. This example provoked at least one attendee to compare it to the infamous “50-state spreadsheet.” Some specialists even suggested that states create special penalties for failure to properly disclose or create the required substantiation.
As some commentators acknowledged, a substantial concern with both the disclosure and substantiation suggestions is the risk of a significant increase in the cost of compliance for taxpayers. State authorities should carefully consider the risk/rewards of any such action. Increased state disclosure requirements, such as modeling the federal uncertain tax position rule, have not yet widely caught on among the states despite spurts of activity. This is partially because of the administrative burden on taxpayers and partially because states receive a great deal of information from the Internal Revenue Service. It is clear, however, that the states continue to be frustrated with the perceived tax planning problem. The specialists expressed near-unanimous agreement that states need more information to properly enforce intercompany transaction issues.
The second theme of the day was the concept of safe harbors. This theme took different forms but could be something that both taxpayers and state revenue authorities would support. For example, some specialists suggested that for low-value transactions, safe harbor rules be created to provide increased certainty to taxpayers. This might include providing limits on the percentage profit that could be made from certain types of intercompany transactions. Other commentators and some states suggested, however, that additional safe harbor protections are unnecessary because state add-back statutes effectively provide safe harbor protection.
In a glaring omission, specialists failed to recognize or address the need to avoid double taxation. Although several specialists noted that in the international area, most of the action happens [...]
On October 6 and 7, 2014, the Multistate Tax Commission (MTC) will hold an Arm’s-Length Adjustment Service (ALAS) Advisory Group Conference at the Atlanta Airport Marriott. On the first day, third-party contract auditors will give presentations on transfer pricing issues. An ALAS Advisory Group meeting will be held on the second day.
This past year, the MTC has been designing a joint transfer pricing program. So far, nine members have committed money to the development of this program: Alabama, the District of Columbia, Florida, Georgia, Hawaii, Iowa, Kentucky, New Jersey and North Carolina.
Dan Bucks, former executive director of the MTC and former director of the Montana Department of Revenue, is the project facilitator. In the lead-up to the event, he discussed arm’s-length issues with numerous third-party contract auditors. On October 6, the contract auditors will explain how they believe a multistate transfer pricing program should work and how the MTC would best use their services to conduct transfer pricing audits on behalf of member states.
The list of contract auditors includes Chainbridge Software, Economics Analysis Group, Economists Incorporated, NERA, Peters Advisors, RoyaltyStat and WTP Advisors. While project facilitator, Dan Bucks, has indicated that this meeting is not an audition for a procurement process, the discussion seems to be headed in that direction and the MTC has not ruled out utilizing third-party audit assistance in the transfer pricing program.
Businesses concerned with the overall direction of the ALAS Advisory Group, including the possibility of subjecting taxpayers to Chainbridge-style audits on a nationwide scale, should contact the authors. For more information on the conference, please visit the MTC ALAS webpage.