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.

History

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)[1] program.  States thus have increasing external resources available for transfer-pricing audits.

International Context

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.[2]  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, [...]

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