Navigating Transfer Pricing and its Impact across US States: A Simplified Guide
In the world of taxation, transfer pricing plays a crucial role preventing profit shifting by a multinational corporation's, ensuring fairness, and preventing companies from creating unfair tax advantages through pricing.
It's a complex area, but understanding the basics is essential for any state tax professional practicing in the United States.
What is Transfer Pricing?
Transfer pricing is the calculation of the prices set for cross border transactions in goods and services conducted between related entities, such as a parent company and its subsidiaries. A multinational company can lower its overall tax burden by shifting profits from a high tax country to a low tax country through controlled transactions in which the prices are adjusted favourably.
For this reason, intercompany transactions are often subject to scrutiny. To ensure controlled transactions reflect market prices, companies and tax authorities may generally utilize an approved transfer pricing method that best suits the economic and financial circumstances of the transaction.
While transfer pricing issues are most commonly associated with the cross border transactions of a multinational corporation, practitioners should note that these issues may be relevant to an intercompany transaction involving two US states.
A Practical Example
Imagine a Utah based parent entity, "Company X", owns a valuable patent. It's Indiana based subsidiary, "Company Y", licenses the patent in order to manufacture a highly profitable product.
Utah has a lower corporate income tax rate of 4.65% compared to Indiana rate of 4.9%. So, where would the multistate company prefer to be taxed on the net profits generated by Y's product sales? Naturally, it would prefer to be taxed in lower tax jurisdictions, which in this case is Utah. A tax strategy emerges whereby Y could pay an inflated royalty licensing fee to X. This strategy has two advantages:
- Y would deduct the royalty fee from its profits in Indiana, reducing its taxable income in the higher tax state (i.e. Indiana), and
- X would include the royalty fee as income in Utah, increasing its taxable income in the lower tax state (i.e. Utah).
Multistate companies could use pricing strategies (i.e. transfer prices) of this nature to manipulate transactions to their advantage and lower their overall tax burden. National and subnational governments alike have enacted transfer pricing regulations and laws exist to prevent such tax avoidance strategies.
The "Arm's Length" standard
To ensure related party transactions are set at fair prices, tax authorities around the world, including the United States, rely on the arm's length principle. This internationally accepted standard requires related entities to set prices that are consistent with prices that would otherwise be set by unrelated entities in similar circumstances. In essence, related companies must act as if they were unrelated, and price transactions in a way that closely resembles the market price.
Calculating Transfer Pricing Method
Calculating transfer prices that approximate market values is achieved by employing various methodologies, the most common of which are:
- the Comparable Uncontrolled Price method,
- the Resale Price method,
- the Cost Plus method,
- the Comparable Profits method, and
- the Profit Split method.
US regulators and courts have interpreted federal law regarding the allocation of income and deductions to allow all five of the above transfer pricing methods, provided they produce an arm's length result.
As such, the IRS is permitted to adjust the taxable transactions of US multinational companies in order to ensure accurate income reporting at the federal level.
Approaches Used by States
While some states have begun incorporating transfer pricing into their law, most US States address intercompany transactions through a combination of various statutory apportionment requirements, including related party expense add-backs and disallowances and economic substance requirements. The most common requirement is mandatory combined reporting.
Combined reporting requirements
Combined reporting addresses profit shifting by related parties by effectively eliminating intercompany transactions. It requires all entities within one multistate company to file a single tax return within the state. The group pools income and expenses before apportioning profits to states in which they operate.
The apportionment itself is based on formulas determined by the individual states, not on an arm's length standard. State apportionment formulas usually based on a ratio of payroll, property, and/or sales attributable to the state.
Tax authorities generally seek to favour combined reporting requirements over transfer pricing methods because they have the potential to generate higher revenue for the state. Combined reporting is also simpler for tax authorities to assess because the apportionment formulae are more easily quantifiable than the arm’s length standard.
The wild, wild west of US state transfer pricing laws
Navigating the state-by-state landscape of transfer pricing laws is not always straight forward. Most states have no explicit laws allowing for transfer pricing practices based on the arm's length standard. However, a growing number of state courts are approving the use of transfer pricing methods by multistate companies to calculate their tax liabilities.
Litigation to look out for
Tax professionals should be on the look-out for litigation in states with ambiguous statutes or regulations. Taxpayers have already brought cases regarding language such as "fair profit" and "necessary in order to prevent evasion of taxes," which the taxpayers arguing are similar enough to federal law that has been interpreted to allow transfer pricing principals. However, courts have also interpreted state laws to allow authorities to enforce combined reporting for tax purposes.
For example, in the 2018 landmark state case Tax Comm'n v. See's Candies, Inc., the Utah Supreme Court affirmed the significance of federal transfer pricing principles in states with similar statutory provisions. The Court held that the Utah Tax Commission could not adjust a transfer price that was based on the arm's length standard. Conversely, in 2023 the South Carolina Administrative Law Court held in Tractor Supply Co. v. S.C. Dept. of Revenue that the South Carolina Department of Revenue may accept either apportionment methods based on reliable transfer price studies or require combined reporting.
Key Takeaways
The landscape of US subnational transfer pricing laws varies significantly from state to state and continues to evolve with an increasing number of states adopting the arm’s length principle through legislative measures and court rulings.
Understanding the intricacies of the transfer pricing regulations is essential for tax lawyers who advise multinational corporations and other multistate entities. By staying abreast of the latest developments in this complex area, tax professionals can help their clients navigate the challenges and ensure compliance with applicable tax laws.
IBFD's transfer pricing services and offerings
IBFD offers top-class transfer pricing resources including databases, tables and charts, an International Transfer Pricing Journal, online courses, and books.
These products will help your transfer pricing practice with transfer prices, transfer pricing disputes, transfer pricing methodology, and your transfer pricing audit.
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