Complying with Expanding State Transfer Pricing Rules
Poniachek, Harvey, The CPA Journal
Strategies for Multistate Corporations
Aggressive state audits and adjustments relating to intercompany transactions - specifically those involving intercompany royalty payments and service charges - could affect multistate corporations that engage in transfer pricing. Many states generally follow the transfer-pricing methodology under Internal Revenue Code (IRC) section 482 by enacting laws that adopt IRC section 482 or by granting analogous authority to their revenue commissioners (Cara Griffith, "States' No-HoldsBarred Approach to Auditing Transfer Pricing Arrangements," BNA Tax Analysts Practice Notes, Feb. 13, 2012). In order to challenge advanced-pricing agreements and other IRS taxpayer agreements for state tax purposes (specifically those related to the ownership and location of intangible property), some states have extended their authority (Technical Advisory Memorandum [TAM] 2012-1, New Jersey Division of Taxation, Feb. 16, 2012, http://www.state.nj. us/treasury/taxation/pdf/pubs/tams/tam20 1 2l.pdf; Brian Trauman and Nicole Crighton, "United States: State Tax Implications of Transfer Pricing Issues," KPMG Tax News Flash 201 1^19, Aug. 15, 2011).
Some states have extended the regulatory scope of their transfer-pricing administration by applying ad hoc approaches that, in addition to the arm's-length principle, utilize economic substance tests or impose unitary business filing requirements (Kathryn E. Rice, "The Challenges of State Transfer Pricing," Tax Advisor, AICPA, Sept. 1, 2010). The enforcement of transfer pricing rules can represent a significant source of revenue for states (Trauman and Crighton 2011). But although state revenue authorities can reject or challenge cases decided by the IRS, they risk exposing taxpayers to double taxation.
Unitary Filing and Transfer Pricing Adjustments
In a unitary filing, states require that corporate income tax be prepared on the basis of total organizational income; income is split among the states on a gross-to-gross basis of sales, assets, or another allocator. (See the Multistate Tax Commission's "Proposed Model Statute for Combined Reporting," amended on Jul. 29, 201 1 .)
In early 2010, 24 of the 47 states that apply income tax on corporations employed the "unitary combined reporting" method of taxation ("Spotlight on SALT: The Global Reach of the State Unitary Tax Regimes," Baker, Donaldson, Bearman, Caldwell & Berkowitz PC, Feb. 23, 2010). The unitary approach has expanded in recent years to Vermont in 2006; New York in 2007; Michigan and Texas in 2008; and Massachusetts, West Virginia, and Wisconsin in 2009. The U.S. Supreme Court has upheld "worldwide unitary combined reporting" as constitutional (Toni Rembe, "U.S. Supreme Court Upholds Worldwide Combined Methodology," Pillsbury Tax Page, http://www.pmstax.com/state/ barclays9408.shtml); however, the "water' sedge combined reporting" is now the norm, which includes only those members of the unitary group that are U.S. corporations.
For example, California applies the 80/20 rule, where 20% or more of the average of a foreign corporation's property, payroll, and sales are within the United States (not just in California), and then all of its income and apportionment factors are included in a California water' s-edge combined report. In another example, a foreign corporation, regardless of its U.S. apportionment factors, is included in a Massachusetts unitary combined report if more than 20% of its gross income comes from licensing intangible property or service-related activities to Massachusetts combined group members.
This author has observed that the unitary approach could be applied for the approximation of interstate transfer pricing, but the burden of proving consistency with the arm's-length principle is likely to rest with the taxpayer. The profit split between the licensor and licensee depends upon the functions performed and risk assumed by the two parties; therefore, it could constitute a wide range of feasible outcomes, including the 80/20 outcome (Stephanie Pantelidaki, Patrick Oparah, and Andrew Hickman, "CUPs and Profit Split- When and How to Use," Transfer Pricing International Journal, December 201 1). …