Transfer Pricing Update - American Bar Association Income Tax Seminar . Transfer Pricing Update . Jill Weise, Managing Director – Transfer Pricing Duff & Phelps, LLC . Salem, MA

Advanced Income Tax Seminar

Transfer Pricing Update

Jill Weise, Managing Director – Transfer Pricing Duff & Phelps, LLC Salem, MA Email: [email protected]

Speakers:

Stephen Kranz, Partner McDermott Will & Emery LLP Washington, DC Email: [email protected]

Scott Brandman, Partner Baker & McKenzie LLP New York, NY Email: [email protected]

2016 Advanced Income Tax Seminar 2

Agenda

• Background: Section 482

• State Transfer Pricing Authority

• State Approaches to Transfer Pricing Issues • Adjustments • Forced Combined Reporting • Addback of Related-Party Expenses • Disguised Transfer Pricing Adjustments

• MTC ALAS Program


Background - IRC Section 482 • IRC section 482 states:

• 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. . .


Background - IRC Section 482 • Due to the brevity of the statute, international transfer

pricing by the IRS is governed almost exclusively by extensive regulations promulgated by the IRS.

• See 26 CFR 1.482-1 through -9. • Outlines specific methods to use in certain

situations and specific rules/examples for tangible goods, intangibles and services.


Background – IRC Section 482 • Fundamental concepts in applying section 482 include:

• Arm’s Length Standard • Best Method Rule

• Comparability • Quality of data and assumptions

• Arm’s Length Range (IQR) • Burden of Proof—if an allocation is made, taxpayer

bears the burden to prove that the IRS’s determinations are incorrect, either by establishing: 1. That the IRS’s determination was arbitrary,

capricious, or unreasonable; and 2. That its prices were arm’s length under § 482.


State Transfer Pricing Authority • Most states generally provide broad

discretionary powers to the State Commissioners of Revenue, allowing them to make adjustments on a similar basis (“State 482 Powers”).

• Nearly every state adopts some statutory regime to adjust transfer prices of intercompany transactions.

• Notable states that do not include: • Delaware; • New Mexico; and • Pennsylvania.


State Transfer Pricing Authority • Some states explicitly adopt the IRC by cross-

referencing the federal statute on a rolling basis or as of a certain date.

• E.g., Alabama, Arkansas, Maryland. • Other states implicitly claim adoption of the

IRC by adopting a state statute with the same/substantially similar language.

• E.g., Connecticut, D.C., Kentucky. • Still others implicitly adopt the IRC by using

federal taxable income before NOLs and special deductions as the starting point for calculating state corporate taxable income.


State Transfer Pricing Approaches • State Departments of Revenue generally

exercise their State 482 authority to allocate and adjust income during an audit, and such adjustments often produce large assessments of liability for the taxpayer.

• Accomplished via:

1. Transfer pricing adjustments; 2. Forced combined reporting; 3. Addback of related-party expenses; and 4. Disguised transfer pricing adjustments.


State Transfer Pricing Adjustments • States currently examine intercompany pricing

closely and in certain jurisdictions, aggressively adjust transfer pricing for audited taxpayers.

• Very few states have either the experience or the technical resources required to properly evaluate transfer pricing.

• While some states have relied on outside consultants to prepare transfer pricing analyses to support tax assessments, these analyses often are technically weak and their relationship to ensuing tax assessments can be nebulous.


State Adjustments – Contingent Fees • Unlike the IRS, which employs a significant team

of international examiners, tax attorneys and economists who specialize in transfer pricing matters, the states generally are inexperienced in transfer pricing theory and law.

• A number of states currently rely on outside

experts, including economists, to assist with transfer pricing audits.

• Often engaged on a contingent fee basis!


State Adjustments – Contingent Fees • The outside expert is hired to review the

taxpayer’s financial data and transfer pricing methodologies.

• The expert in turn presents a report to the

state detailing whether the taxpayer’s transfer prices are, in their view, consistent with the arm’s length standard.

• The report serves as the primary – indeed,

often the sole – basis for the state’s transfer pricing adjustments.


Issues Raised – Contingent Fees • Legal:

• Potential violations of taxpayer confidentiality statutes;

• Unlawful delegation of authority; • Prohibitions of tax collection based on amounts

collected. • Practical/Ethical:

• Burden shifts to taxpayer to prove a negative (post-assessment);

• Contingent fee raises bias and conflict of interest issues;

• No disclosure of methodology behind assessment.


State Adjustment Examples • District of Columbia Chainbridge cases:

• Microsoft

• Shell, Hess and Exxon

• Oral arguments for consolidated appeal held before D.C. Court of Appeals on Feb. 9.

• Siemens, Ahold, AT&T, Eli Lilly, Pfizer.

• BP Products North America Inc.


Forced Combined Reporting • Forced combined reporting often occurs regardless

of whether the intercompany transactions between unitary group members are conducted at arm’s length.

• E.g., Massachusetts • “The requirement to file a combined report is

not dependent upon an evidentiary showing that there is a distortion of income between corporations that are related by common ownership or that there is a lack of arm's length pricing in transactions between such corporations.” 830 CMR 63.32B.2.


Forced Combined Reporting • But see, Indiana • The DOR has taken the position it will disregard

a federal transfer pricing study in requiring parent and subsidiary to file a combined Indiana corporate income tax return.

• Indiana Letter of Finding No. 02-20130641

(2/25/2015) (stating “transfer pricing studies are not Indiana-approved vehicles for justifying tax expenses through controlled party profits”).


Forced Combined Reporting

• Rent-A-Ctr. E., Inc. v. Indiana Dep't of State Revenue, 42 N.E.3d 1043 (Ind. T.C. 2015).

• On remand from the Indiana Supreme Court, the Indiana Tax Court held that the taxpayer did not have to file a combined return with its out-of-state affiliates in part because the company’s transfer pricing rates were at arm’s length, as evidenced by the transfer pricing study submitted by the taxpayer.


Addback of Related-Party Expenses • To combat IHCs, states have implemented

statutes that generally disallow deductions for intercompany intangible expenses incurred between related parties.

• The most common types of intangible

expenses addressed in these statutes are interest and royalties.

• Some states have exceptions to the addback statute for intercompany transactions with entities in countries that have a U.S. Tax Treaty.


Addback of Related-Party Expenses • Kimberly-Clark Corp. v. Comm’r (Mass. App. Ct. Jan.

11, 2013) • Held that a taxpayer must show by “clear and

convincing” evidence (rather than “preponderance of the evidence”) the presence of both economic substance and valid business purpose as well as that tax reduction was not a principal purpose of the transaction to be entitled to claim an exception to the addback statute;

• Statute creates a presumption that covered expenses are to be added back/disallowed, burden on taxpayer to rebut this presumption to satisfaction of the DOR.


Disguised Transfer Pricing Adjustments • Some states have attempted to impute an embedded

royalty on intercompany sales of tangible personal property. See 830 Mass. Regs. Code 63.31.1.

• An embedded royalty is not deductible and is subject

to addback.

• The addback of an embedded royalty effectively results in a de facto transfer pricing adjustment. 830 Mass. Regs. Code 63.31.1(3)(a).


Disguised Transfer Pricing Adjustments • Other states have successfully asserted that a

corporate parent’s in-state activity confers nexus on its out-of-state subsidiary, typically an IHC, on the basis that the out-of-state subsidiary lacks economic substance as a separate business entity. • See, e.g., Syms Corp. v. Commissioner, 765 N.E.2d

758 (Mass. 2002); Comptroller of the Treasury v. SYL, Inc., 825 A.2d 399 (Md. 2003).

• Presumes that the parent’s in-state business

produces the subsidiary’s apportioned income.


Disguised Transfer Pricing Adjustments

• Transactions are examined to determine whether they have a valid, non-tax business purpose and economic substance.

• E.g., Maryland economic substance cases: • Gore Enterprise Holdings, Inc. v. Comptroller of the

Treasury (Md. 2014). • ConAgra Brands Inc. v. Comptroller of the Treasury

(Md. Tax Ct. Feb. 24, 2015).


MTC ALAS Program • Major fiscal problems exist due to businesses

shifting income to more favorable jurisdictions. • Revenue loss estimates:

• Federal - $100B • States - $20B

• Cost is prohibitive for states to deal with these issues individually. • The Multistate Tax Commission initiated the

program in 2013 under the idea that states would be able to pool resources and audit a single taxpayer for a number of states at once.


MTC ALAS Program - Timeline • May 2013 – Genesis of Project

• MTC Executive Committee Meeting • Michael Bryan former NJ Director of Taxation

• June 2014 – ALAS Advisory Group Initial Meeting • Dan Bucks is Project Facilitator • Former MTC Executive Director • Former Director of Montana DOR

• October 2014 – Meeting with Third Party Experts • RFP Issued for Training Proposal

• February 2015 – Solicitation letters sent • 4 Year Commitment


MTC ALAS Program – Current Status • MTC sent invitation letter to 47 states and D.C. to

identify charter members of program.

• Six (6) states have formally committed resources to the program— • Alabama, Iowa, Kentucky, New Jersey, North

Carolina, Pennsylvania. • This is an insufficient number of states to

officially launch the program. • Final Program design approved by MTC Executive

Committee on May 7, 2015.


MTC ALAS Program – Training • March 31-April 1, 2015 – Training Program held

course for 10 States by Third Party Contractor. • Attendees included Alabama, Connecticut,

Florida, Georgia, Iowa, Kentucky, Louisiana, New Jersey, North Carolina, and Pennsylvania.

• Ednaldo Silva, former Senior Economic Advisor with

Office of IRS Chief Counsel and part of the team which drafted IRC 482 regulations.

• Similar training will continued to be offered on an as needed basis, whether ALAS is implemented or not.


MTC ALAS Program – Highlights

• Interrelated service elements, all mutually supportive: • Training. • Analysis of Transfer Pricing Studies. • State Capacity Building—Beyond Training. • Optional Joint Audits (through Joint Audit

Program).

• Additional service elements: • Early voluntary disclosure program. • “Advanced Pricing Agreements” through existing

ADR process.


MTC ALAS Program – Highlights • Staffing of project

• Over the charter period, it is projected that ALAS will hire three economists, an attorney, a tax manager, and a pricing auditor.

• ALAS will also use third party consultants

• However, the consultants will not be paid based on a contingent-fee arrangement.

• Budget

• FY 2016: $1.25MM FY 2018: $2.213MM • FY 2017: $2.25MM FY 2019: $1.954MM


MTC ALAS Program – Highlights • Costs to State to Participate

• 4 year commitment (with possible exceptions) • Costs will vary by state, depending on:

• How states use the program • Number of participant states • Size of State in terms of corporate tax revenue

• Approximately $200,000 per year, per state.

• Estimated Revenues • $110MM over the 4 year charter period.


MTC ALAS Program – Questions • Are states going to follow through with developing

resources dedicated to transfer pricing? • What is the impact for consolidated/combined return

states? • Separate return vs. consolidated/combined return

states; variances to approach • Is attention being drawn by the OECD’s BEPS Project

going to accelerate the states’ activities? • To what extent will states’ efforts be enhanced by

information sharing from the IRS? • Access to information from country-by-country

reporting


Questions? • Steve Kranz, Partner McDermott Will & Emery LLP (Washington, DC) [email protected] • Jill Weise, Managing Director – Transfer Pricing

Duff & Phelps, LLC (Salem, MA) [email protected]

• Scott Brandman, Partner Baker & McKenzie LLP (New York, NY) [email protected]

Documents

Transfer Pricing Update - American Bar Association Income Tax Seminar . Transfer Pricing Update . Jill Weise, Managing Director – Transfer Pricing Duff & Phelps, LLC . Salem, MA