Tax

States Beefing Up Their Transfer Pricing Audit Resources

July 2015
Author:  Jason Eberhardt

Jason Eberhardt

Senior Managing Consultant

International Tax Services

375 N. Shore Drive, Suite 501
Pittsburgh, PA 15212-5866

Pittsburgh
412.364.9395

Transfer pricing has become one of the biggest focus areas for the IRS in recent years as the agency looks to generate additional tax revenue. While the IRS primarily has focused on international transfer pricing issues, the states have quietly assessed companies’ domestic transfer pricing positions over the past 10 years with the same objective of generating additional tax revenues. Unlike international transfer pricing audits, which have garnered significant publicity over the past few years, domestic transfer pricing challenges rarely make the news.

The lack of high-profile state tax audits is due in part to a lack of resources. In the U.S., Internal Revenue Code Section 482 gives the IRS the power to challenge the arm’s-length nature of intercompany transactions and adjust income and deductions to properly reflect taxable income at the federal level. The IRS employs a team of economists and transfer pricing specialists to enforce those regulations. Many state taxing authorities have similar powers to adjust income and expenses related to intercompany transactions between domestic affiliates, but states lack the requisite economist resources to tackle complex issues that may arise during the course of a multifaceted transfer pricing audit.

The Multistate Tax Commission (MTC), an intergovernmental state agency that aims to create uniform state tax policies, is attempting to augment state tax authorities’ transfer pricing capabilities by creating the Arm’s-Length Adjustment Service (ALAS), a dedicated transfer pricing audit program. The objective of ALAS is to pool resources from multiple states to develop sufficient transfer pricing economist availability that can be shared by member states in conducting transfer pricing audits and providing litigation support. The ALAS advisory group plans to create a team of six transfer pricing specialists, including a manager, an auditor, economists and an attorney. Until this team is fully functioning, ALAS likely would leverage outside consultants for economics expertise. 

If the plan goes ahead, the ALAS advisory team is considering a four-year development period during which it expects to generate more than $100 million of additional tax revenue at a cost of only $2 million per year for the participating states. Project funding has been the major roadblock thus far. While it’s projected to generate significant return on investment, the MTC has been unable to convince any states to formally sign up for the program as of the date of this article; the commission will need at least seven states to sign up for the four-year term for the program to be economically viable. The lack of registrants is perceived to be more connected with the length of the four-year agreement than lack of faith in the program’s ability to meet its objectives.

While the MTC attempts to rally support for ALAS, it has moved forward with training programs designed to more fully educate state auditors regarding transfer pricing issues. It conducted its first training session using external consultants in March 2015 and is expected to conduct additional training sessions in the future.

It’s unclear whether the MTC will sign up enough states to fully fund ALAS, but states certainly will continue to go after taxpayers with aggressive transfer pricing positions using all available resources. As with multinational tax positions, we recommend taxpayers prepare and maintain transfer pricing documentation to support interstate related-party transactions, particularly those involving separate filing states.

For more information on how these trends could affect your organization, contact your BKD advisor.

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