When considering the role of transfer pricing, many often view it as a purely international endeavor. However, as transfer pricing has continued its rise as a topic of interest throughout the tax world, state governments have become increasingly involved in scrutinizing domestic intercompany transactions within the United States. In fact, even in many cases where the IRS doesn’t care about transactions between US entities, some State Departments of Revenue (“DORs”) do.
While domestic related party transactions are often overlooked when taxpayers are preparing transfer pricing documentation, state tax authorities are escalating audits of intercompany transactions, as transfer pricing crackdowns in several states are generating millions in tax revenue.
Domestic Transfer Pricing in the US
Federally, transfer pricing in the United States is regulated by section 482 of the IRS’ Internal Revenue Code. Many state DORs, especially in separate reporting states, have implemented rules which parallel section 482.
Often, State DORs are not constrained by the arm’s length standard. They have frequently applied pressure using concepts like economic substance when conducting audits. This offers alternate ways for state DORs to scrutinize transfer pricing.
The Difference Between Separate and Combined Reporting States
Understanding the differences between separate reporting states and combined reporting states is key to being prepared for any potential complications that can arise.
In separate reporting states, each corporation within an affiliated group is required to file its individual tax return. This treatment considers them as separate entities with independent income, recognizing intercompany transactions, and allowing for varying tax liabilities. States that require separate reporting are more impacted by the arm’s length nature of transactions between related parties as they are more at risk of their tax base being eroded due to these transactions.
In contrast, combined reporting states require or allow affiliated corporations within a corporate group to file a single tax return, treating them as a unitary business with shared income, often eliminating intercompany transactions. States which have adopted the unitary tax concept have created specific requirements as to when a company can be required or permitted to file a combined return. Companies often face difficulties in combined reporting as rules may vary from state to state. As a result, there have been controversies as it relates to the perspective of fairness and accuracy.
Out of the 45 states which require corporate income filing, there are currently 17 states which require separate reporting, while 28 states (plus D.C.) require combined reporting.
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Recent Developments and Trends
Over the past several years, state transfer pricing interest has seen continued growth in sophistication and volume. Both separate reporting states and combined reporting states have been increasing investment in the transfer pricing field. Not only are DORs increasing headcounts and intensifying the training of staff, in some states, like New Jersey, we’ve even seen the hiring of third-party consultants to assist in transfer pricing matters.
In the past, examinations at the state level have often been criticized for challenges caused by a lack of transparency and consistency. Recently, some states have begun implementing voluntary transfer pricing resolution programs. In 2021, Louisiana created its “Managed Audit Program” with the aim to resolve issues proactively by providing incentive for companies to voluntarily be audited. Other states like North Carolina and Indiana have also taken steps to resolve transfer pricing issues more quickly.
These programs can be interpreted as signals of a looming threat of future increased audit activity. Transfer pricing audits and the potential adjustments they promise represent potential avenues for states to generate income post-Covid pandemic.
Remaining Diligent
As we see continued advancements and innovations around the world, we find the same with state DORs. With transfer pricing remaining an area of focus for states, taxpayers must stay aware and stay prepared for increasingly aggressive audits within the United States.
It continues to be vital to review intercompany transactions at the state level in a routine manner. Keeping up to date with documentation to support the arm’s length nature of these transactions is critical to staying compliant with state tax demands.
Transfer pricing documentation consists not only of principal documents, such as the study itself, as well as supporting documents like the intercompany agreement. As states rely on these agreements as the first step for their review, they are vital both in form and in substance.
Ultimately, taxpayers who are diligent in keeping contemporaneous with documentation requirements will be best prepared to handle escalating scrutiny from state tax audits.
