Buzz in the Beehive State: Court Decision May Affect Transfer Pricing Disputes

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A state tax court case decided on October 6, 2016, by the 4th Judicial District Court in Utah County has wide-ranging implications for the resolution of future state tax transfer pricing disputes. In See’s Candies, Inc. v. Utah State Tax Commission, the Utah State Tax Court found that the arm’s-length standard as set forth by Internal Revenue Code (IRC) Section 482 is an appropriate means of reallocating income pursuant to Utah Code Section Ann. 59-7-113, which was found to be identical to IRC §482.

The Background

See’s Candy Shops, Inc. (See’s), a California corporation, had nexus in the state of Utah through its retail stores. In 1997, See’s sold its intellectual property (IP) to a related party, Columbia Insurance Co. (Columbia), in exchange for stock in another related party as part of a tax-free transaction. After the transaction, See’s paid a royalty to Columbia. The values of the IP transfer and the royalty payment were supported by a valuation and transfer pricing study prepared by a third party, which was performed according to the principles of IRC §482. Both See’s and Columbia are subsidiaries of Berkshire Hathaway Inc.

See’s and Columbia don’t file on a consolidated basis in Utah. Given that Columbia is an insurance company, it pays Utah state taxes based on its in-state premiums, as opposed to its income. As such, royalty income payable to Columbia by See’s isn’t taxable in Utah. However, the royalty payment by See’s is deductible for tax purposes, resulting in significantly lower Utah state tax for See’s.

The Issue

For federal tax purposes, IRC §482 permits the IRS to redistribute, reallocate or reapportion certain items of gross income, deductions, credits or allowances among affiliates if it determines such an adjustment is necessary to prevent tax evasion or to clearly reflect income. The wording in Utah Code Section Ann. 59-7-133 is almost identical to that of IRC §482, but unlike IRC §482, it provides no guidance or regulations on how to apply the rules.

Most states adopt some sort of statutory regime to adjust intercompany pricing arrangements between related parties. While many states have statutes that are essentially identical or similar to IRC §482, a few states assert that their statutory authority is broader than IRC §482. Unlike international cross-border intercompany transactions, which rely on the arm’s-length standard under IRC §482, a large number of states rely on formulary apportionment for determining taxable income earned in each state, negating the need to employ IRC §482. As a consequence, there are relatively few court cases involving transfer pricing at the state level.

In the See’s case, the Utah Tax Commission (UTC) asserted that Utah Code Section Ann. 59-7-133 allows them unfettered authority to reallocate income upon finding a distortion of income for tax purposes and that IRC §482’s principles don’t apply when interpreting Utah Code Section Ann. 59-7-113. Therefore, the UTC’s position was that it can essentially disregard IRC §482 when analyzing transactions between related parties. See’s rebuttal to this position was that IRC §482 rules apply, otherwise the UTC would have unbridled power to reallocate income among related parties. See’s further noted that the Utah attorney general issued an informal opinion that federal rules should apply to the application of Utah Code Section Ann. 59-7-113 in 1979.

The UTC disallowed the entire royalty payment paid by See’s to Columbia for the years 1999 to 2007 under the premise that the royalty income isn’t taxable to Columbia and the transactions lacked a valid business purpose. In denying the deduction, the UTC asserted that, under Utah Code Section Ann. 59-7-113, it had unfettered authority to reallocate income and didn’t have to respect the taxpayer’s position that it was in conformance with IRC §482 and could ignore the taxpayer’s transfer pricing study.

The Findings

The Utah Tax Court ruled against the UTC and determined it abused its discretion by denying See’s its full deduction for royalty expenses paid to Columbia when the related-party arrangement was supported by a transfer pricing study prepared by a reputable third party. More importantly, the tax court found the UTC’s authority to reallocate income was limited by the regulations under IRC §482, because state law under Utah Code Section Ann. 59-7-133 is virtually identical to IRC §482. There’s nothing in the statutory scheme to indicate transfer pricing guidance is derived from anything other than the IRC §482 regulations. Therefore, the Utah Tax Court sided with the taxpayer and found its transfer pricing study was acceptable and should be respected. However, the Utah Tax Court did reduce the royalty rate to the lower end of the range of the transfer pricing study. Perhaps not surprising, the UTC didn’t agree with the Utah State Tax Court’s findings and filed an appeal on November 3, 2016.

The Takeaways

State tax authorities are increasingly pursuing transfer pricing adjustments in an attempt to close the gap on state deficits. The tactic these states employ is similar to that of the UTC, where the state tax authority has broad authority to reallocate income and doesn’t have to respect the arm’s-length principles under IRC §482 and can, therefore, willingly and knowingly ignore the taxpayers’ transfer pricing studies. In two recent court cases (Rent-A-Center East, Inc. v. Indiana Department of State Revenue and Columbia Sportswear USA Corp. v. Indiana Department of State Revenue), the Indiana Department of State Revenue lost after asserting that IRC §482 doesn’t apply and was ultimately forced to concede that it should apply in future disputes and that taxpayers’ transfer pricing studies cannot be set aside.

Taxpayers should document their state intercompany pricing arrangements, as there’s a higher likelihood of avoiding a transfer pricing adjustment and having the state tax authority use broad discretionary powers against them. Taxpayers and state tax advisors are anxiously awaiting a final decision by the Utah state supreme tax court, as it will serve as a precedent in other similar state transfer pricing-related disputes.

Contact your trusted BKD advisor for more information.

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