Traditionally, when we think of transfer pricing, it is in the context of international business transactions. A business may set up an entity in a tax haven to hold its intangible property, such as intellectual property, and charge the operating businesses for the use of the property. The use of transfer pricing practices on a multi-state basis to shift income into a low or no tax jurisdiction is not a new concept.
Many businesses have likely heard about Delaware holding companies. Delaware granted special status to entities that limited their activity to the ownership, management, and disposition of intangible property. These entities do not pay any corporate net income tax on their profits in Delaware. As a result, it generated a flurry of activity for businesses to isolate their intangible property, such as intellectual property and cash, and to deposit those assets into a Delaware holding company.
Such planning became a mainstay in multi-state corporate income tax restructurings. The technique eventually became a method of shifting income between related entities for personal income taxes, as well. Businesses began utilizing management fees to shift income to pass-through entities that were located in a low or no personal income tax state, such as Nevada or Florida. These strategies were extremely successful, especially when the owner of the pass-through entity resided in one of these low or no income tax states.
Over the years, states have used various methods to attack transfer pricing strategies to minimize the loss of state revenues attributable to these planning techniques. Broad discretionary powers were enacted in order to allow states to reallocate income on a more equitable basis between related parties. There has also been other anti-abuse legislation such as mandatory combination, related party addbacks, and the expansion of nexus standards. The taxpayer defense of transfer pricing methodologies has been favorable over the years and states have had to adhere to the federal guidelines related to challenges to transfer pricing.
As a result of COVID-19 and states’ need for revenue, domestic transfer pricing strategies are once again coming under scrutiny to determine whether businesses are paying the appropriate level of state taxes. States are beginning to collaborate with one another and sharing information aimed at strengthening audit procedures and creating competent capabilities to enforce the arm’s length standards used to validate related party transactions. Indiana and North Carolina have both created advanced pricing agreement programs modeled after the federal programs dealing with cross-border transactions. Several other states have enlisted the expertise of third-party consultants to assist in their efforts.
Businesses that primarily file in separate company reporting states and derive a significant benefit from related party transactions should be prepared for the increased scrutiny of these transactions. Based on what we have seen in several recent audits, states are beginning to look at these transactions as a regular part of the audit procedure. In anticipation of the increased pressure on these transactions and the need to prove that the pricing is valid, businesses need to respond to the likelihood that states will become more aggressive as their capabilities continue to improve. They should revisit the basis for their transfer pricing to determine whether the methodology continues to justify the transfer price in today’s economic environment and to ensure that the proper documentation is maintained to support the pricing.
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