More formal, rigorous, and perhaps more frequent, state transfer pricing audits appear to be looming on the horizon, as the Multistate Tax Commission (MTC) is set to launch a design and development project tasked with presenting a preliminary draft program by year’s end, with a final program recommendation due by the MTC’s annual meeting in July 2015. The intent would be to create a dedicated MTC program, including staff, that would assist, as well as train, member states (both combined and separate reporting states) in conducting state transfer pricing audits as an alternative to hiring contracted consultants.
Transfer pricing is usually considered an international affair, but state governments are increasingly becoming involved in efforts to implement interstate transfer pricing methodologies to increase revenue without publically increasing taxes. Unfortunately, recent history demonstrates that these methods can be faulty because they trade accuracy for expediency, and most are in need of serious modification. See e.g., Microsoft Corp., Inc. v. Office of Tax and Revenue, Case No. 2010-OTR-00012 (D.C. Office of Administrative Hearings, May 1, 2012), which concluded that the Chainbridge Software transfer pricing program used by the District of Columbia was “arbitrary, capricious, and unreasonable.” (There are at least four additional cases pending in the D.C. Office of Administrative Hearings over transfer pricing income adjustments and the use of Chainbridge Software programs by the D.C. Office of Tax and Revenue.)
It comes as no surprise, therefore, that the Multistate Tax Commission (MTC, or Commission) announced at its recent Audit Committee meeting that it is creating an advisory group of state tax directors to design and develop the outlines of a model state transfer pricing audit program. The project will be led by former MTC Executive Director Dan Bucks, who most recently served as director of the Montana Department of Revenue. The project plan proposes a draft design due date of December 2014 and a final design for submission to the Executive Committee and Commission by July 2015.
The announcement comes a year after the New Jersey Division of Taxation Director Michael J. Bryan challenged the MTC to create a separate, dedicated transfer pricing audit program, or risk a coalition of states splintering off to develop their own program. See Amy Hamilton, MTC to Consider Creating Dedicated Transfer Pricing Audit Program, 68 State Tax Notes 571 (May 20, 2013). All of this has stemmed from a series of recent transfer pricing disputes in the District of Columbia over the “do it yourself” Chainbridge Software transfer pricing program used by the Office of Tax and Revenue.
In announcing the project, the MTC noted that more than a dozen states have come forward to offer their support and seed money to fund the launch of the development phase of the program. Interestingly, the support comes from both separate entity states, such as Alabama, Florida and New Jersey, and combined reporting states (none have been publically identified yet). While the official list of participating states has not been released at this time, it should become available once states are required to designate members to the advisory group. Participating states will be asked to commit three to four years to the program upon its launch. eeSeveral States Willing to Commit Seed Money for MTC Transfer Pricing Audit Program, 2013 State Tax Today 240-1 (Dec. 13, 2013). States will be permitted to participate in one or more of the three services offered under the program (listed below). Combined reporting states are likely to be interested in transactions between the unitary group and other related parties outside the legally limited group, such as foreign related parties, or so-called 80/20 domestic entities.
At this stage, the MTC program is likely to comprise three types of services:
Pre-audit services, consisting of analysis and audit selection, training services, and transfer pricing policy and best practices development
Audit services, including economic services
Post-audit services, including legal assistance with litigation, and expert witness and economic services
The program was recently described as “not a 482 project,” by a former executive director who noted that “[m]ost states are not bound by federal rules,” (seeStates Designing a Multistate Transfer Pricing Audit Program, 2014 State Tax Today 50-2 (March 14, 2014)), and that states were seeking to develop their own approaches to arm’s length adjustments that were simpler, more certain and more effective than their federal processor. Seegenerally I.R.C. § 482. It is possible that these comments evidence intent to expand traditional Section 482 rules to various state-specific remedies such as combined reporting, add backs or collapsing affiliates. It is not clear to what extent existing federal safe harbors would be recognized and whether states would implement state-specific required minimum profit percentages. Hopefully, the MTC will consider remedying the lack of a competent authority concept at the state level at the same time it is seeking methods to increase state revenues. As to the ultimate resolution or even feasibility of this project, only time will tell.
Despite the MTC’s claims to differentiate and distance itself from its national and international counterparts, the MTC transfer pricing project is not all that dissimilar to the Organisation for Economic Co-operation and Development/G20’s Base Erosion and Profit Shifting (BEPS) project, which is equally inclined to eschew traditional transfer pricing concepts and equally ambitious in its timetable to implement change. It will be interesting to see if the MTC is more successful in achieving consensus or effective resolution of transfer pricing matters at the state level than has been the case with attempts of the various national governments.
The McDermott Difference
While dates are still to be determined for MTC meetings where public participation is allowed, representatives from McDermott Will & Emery will be present at any and all such meetings to encourage multistate taxpayers to get involved in this important issue. If you have any questions or would like more information on transfer pricing matters at the state level, please contact your regular McDermott lawyer or an author.