The challenges of state transfer pricing.

• Author: O'Connell, Frank J., Jr.

Transfer pricing is a mechanism used to establish the pricing of various intercompany transactions (i.e., transfers of tangible and intangible property, services, loans, and guarantees) within a multinational or multistate organization. Companies often enter into such transactions with related parties that cross geographic boundaries, and the transfer price used will affect the allocation of the total profit among the different parts of the company. As a result, taxing authorities are inclined to heavily scrutinize those transactions to ensure that a company's revenues and expenses are properly allocated to a particular jurisdiction or legal entity.

In practice, multijurisdictional organizations are obligated to use an external market price test called arm's-length pricing when they price internally for tax purposes. In the United States, federal and state taxing authorities have discretionary power to challenge intercompany transactions by readjusting items of income and deductions to clearly reflect taxable income. These powers are authorized at the federal level by Sec. 482. Although most states have not explicitly adopted Sec. 482, they have granted similar powers to varying degrees to their taxing authorities (see, e.g., CT Gen. Stat. [section][section]12-213(a), 12-226(a), 12-225(a), and (b)(1); MA Gen. Laws ch. 63, [section][section]30.4, 33; NJ Rev. Stat. [section][section]54:10A-4(k), 54:10A-10; NY Tax Law [section]208.9(i); OH Rev. Code. Ann. [section][section]5733.04(1), 5733.031(C); 72 PA Stat. Ann. [section]7401(3)1(a)).

Recently many states have been taking aggressive steps and becoming more sophisticated in challenging intercompany pricing. There have been significant differences, however, in how they have done so (e.g., forcing combined returns versus disallowing deductions). As a result of such differences, disputes inevitably arise given particular taxing authorities' different interests, which arise from the bases on which state taxes are levied. While there are several possible avenues a state may choose to take, many of these challenges will involve imposing mandatory combined reporting, making Sec. 482-type adjustments, disallowing tax-motivated or sham transactions, or applying economic and affiliate nexus standards.

Mandatory Combined Reporting

One of the responses to transfer pricing disputes that has been growing in popularity among the states has been to require combined reporting for groups of affiliated companies. In essence, combined reporting (also referred to as unitary filing) is a method whereby states require corporate income tax reporting on total organizational income. Each state attempts to divvy up income based on a formula that apportions total organizational income by using either in-state sales divided by total sales, in-state property divided by total property, in-state payroll divided by total payroll, or some combination of these three factors. When a business is unitary, the fact that the group consists of separate legal entities is generally...