Ohio Tax State Transfer Pricing Audits Effective Strategies to - - PDF document

27th Annual

Tuesday & Wednesday, January 23‐24, 2018

Hya Regency Columbus, Columbus, Ohio

Ohio Tax

Workshop Z

State Transfer Pricing Audits … Effective Strategies to Minimize Your Risk

Tuesday, January 23, 2018 4:15 p.m. to 5:15 p.m.

Biographical Information

Diann L. Smith, Counsel, McDermott Will & Emery 500 N. Capitol St. NW Washington, DC 20001 dlsmith@mwe.com 202.756.8241 Fax 202.756.8087 Diann Smith is counsel in the law firm of McDermott Will & Emery LLP and is based in the Firm’s Washington, D.C., office. Diann focuses her practice on state and local taxation with an emphasis on tax challenges relating to compliance, controversy, planning and legislative

• activity. Diann has experience representing clients in nexus, tax base, business and non-

business income classification, apportionment and FIN 48 compliance issues. She has also counseled clients on multi-state unclaimed property compliance and voluntary disclosure

• pportunities. Diann has represented clients from a broad range of industries, including retail,

insurance and communications services. Diann has significant experience representing clients before the Multistate Tax Commission (MTC). Prior to joining McDermott, Diann was counsel at another international law firm, where she also focused on state and local taxation. She also previously served as general counsel for the Council On State Taxation (COST). While at COST, Diann worked on nearly every major state and local tax issue confronting multi-state businesses. From 1998 to 2005, Diann was an adjunct professor at Georgetown University Law Center for the LL.M. in taxation program. Diann received her J.D. from the Georgetown University Law Center, where she was an editor

• f the Georgetown Law Journal. She received her B.A. from Miami University. Diann served as

a law clerk to the Honorable Alan E. Norris of the U.S. Court of Appeals for the Sixth Circuit in 1991 and 1992. Diann is admitted to practice in the District of Columbia, Ohio and New York. Ellen Bloch, CPA, Director, International Tax & Business Advisory Services GBQ Partners LLC, 230 West Street, Suite 700, Columbus, OH 43215 614.947.5278 Fax: 614.227.6999 ebloch@gbq.com Prior to joining GBQ in 2017, Ellen spent the past 12 years in Big 4, most recently with EY, where she primarily focused on supporting clients with international tax and transfer pricing matters. Ellen brings diverse tax experiences to clients across many industries including life sciences, consumer products, chemical and industrial products. She works with clients to develop, analyze, and prepare transfer pricing planning, documentation, and audit dispute resolutions, including working with the IRS and foreign tax authorities in audit settlements and advanced pricing agreements. Ellen has worked extensively with companies in understanding and adopting the new global tax and transfer pricing requirements under the OECD BEPS initiative and pending US tax reform. She strives to bring a practical perspective to help clients find reasonable and cost-efficient compliance approaches specific to their needs and priorities. Ellen is also experienced in domestic and international supply chain planning projects, working closely with business and finance teams to design and implement new operating models and related tax planning opportunities. Ellen is a graduate of the University of Akron with a B.S. in Accounting, with Honors. Ellen is a member of the Leadership Columbus Class of 2016.

27th Annual Ohio Tax Conference State Transfer Pricing Audits Effective Strategies to Minimize Your Risk

Diann L. Sm ith

McDermott Will & Emery LLP Washington, DC (202) 756-8241 dlsmith@mwe.com

Ellen J. Bloch

GBQ Partners LLC Columbus, OH (614) 947-5278 EBloch@gbq.com

Agenda

• Introduction
• Overview of Federal Landscape

▫ What is Transfer Pricing? ▫ Statutory Authority ▫ Global Trends

• Overview of State Landscape

▫ State Transfer Pricing Authority ▫ MTC SITAS ▫ Contract Auditors! Oh my… ▫ Recent Developments

• Key Differences – State v. Federal
• State Audit and Controversy Considerations

What is Transfer Pricing?

• The method used to establish pricing of transactions

between related parties for goods, intangible assets, services, and loans.

▫ Related party relationships suspend the normal laws of supply and demand.

• Objective under IRC § 482 is determine an “arm’s

length” transfer price and prevent related parties from artificially shifting income to achieve tax benefits.

▫ A tax evasion or avoidance motive is generally not a prerequisite for application of an IRC § 482 adjustment.

3

S tatutory Authority

• IRC § 482 states:

▫ In any case of two or more organizations, trades, or businesses . . . owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such

• rganizations, trades, or businesses. . .

4

Overview of Federal Landscape

• Due to the brevity of the statute, international

transfer pricing by the IRS is governed almost exclusively by extensive regulations promulgated by the IRS.

▫ See 26 CFR 1.482-1 through -9.

• The regulations outline specific methods to use in

certain situations and specific rules/examples for tangible goods, intangibles and services.

5

Overview of Federal Landscape (cont.)

• Regulations adopt the “arm’s-length” standard:

▫ An intercompany transaction is “arm’s-length” if the results are the same as results realized by uncontrolled taxpayers engaged in the same transaction under the same circumstances. ▫ Id entica l uncontrolled transactions are generally not available – so it is appropriate to consider com p a ra ble uncontrolled transactions.

• Analysis of independent, uncontrolled comparable

transactions is at the center of all transfer pricing analysis.

6

Overview of Federal Landscape (cont.)

• Other key concepts in applying IRC § 482 include:

▫ Best Method Rule

 Comparability  Quality of data and assumptions

▫ Arm’s Length Range (IQR) ▫ Burden of Proof—if an allocation is made, taxpayer bears the burden to prove that the IRS’s determinations are incorrect, either by establishing:

 That the IRS’s determination was arbitrary, capricious, or unreasonable; and  That its prices were arm’s length under § 482

7

Global transfer pricing trends

• Cross-border transfer pricing practices are high

priority for many global tax authorities with increased focus on:

▫ Transparency into the global supply chain ▫ Economic substance ▫ Documentation standards

• US multinational corporations are particularly

under scrutiny globally

8

Global transfer pricing trends (cont.)

• Transfer pricing regulations assume that expected

returns are positively and causally related to the functions performed, assets owned and risks assumed by a given entity.

▫ More functions → higher expected return ▫ More complex functions → higher expected return ▫ More assets owned → higher expected return ▫ Intangible assets owned → higher expected return ▫ More risks assumed → higher expected return

9

S upply Chain Illustration

• Manufacturer is responsible for day-to-day production tasks and

manufactures products under the direction of Parent.

• Sales Company is responsible for customer relationships and execution of

sales strategy established by Parent.

• Parent provides strategic management and oversight to the supply chains,
• wns key intangibles, and bears critical risks.

10 Routine Manufacturer Parent/ Strategic Management Routine Sales Company

Sale of unbranded product Sale of branded product Physical flow of product

S tate Transfer Pricing Authority

• Many states have specific statutes that either adopt or

are substantially similar to IRC 482.

▫ Nearly every state adopts some statutory regime to adjust transfer prices of intercompany transactions (with the exception of Delaware, New Mexico, and Pennsylvania).

• Many states focus on IRC 482 language regarding their

ability to make adjustments if the State “determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of State income taxes” in a manner “consistent with IRC 482 and the rulings, regulations issued thereunder”

11

S tate Transfer Pricing Authority (cont.)

• State DOR’s generally exercise their State 482

authority to allocate and adjust income during an audit, and such adjustments often produce large assessments of liability for the taxpayer.

• Jurisdictions actively assessing on 482 grounds:

Alabama Indiana New York Connecticut Missouri New York City Georgia Mississippi North Carolina Florida New Jersey South Carolina

12

S tate Transfer Pricing Authority (cont.)

• Some states explicitly adopt the IRC by cross-referencing

the federal statute on a rolling basis or as of a certain date.

▫ E.g., Alabama, Arkansas, Maryland.

• Other states implicitly claim adoption of the IRC by

adopting a state statute with the same/substantially similar language.

▫ E.g., Connecticut, D.C., Kentucky.

• Still others implicitly adopt the IRC by using federal

taxable income before NOLs and special deductions as the starting point for calculating state corporate taxable income.

13

Overview of S tate Landscape

• States typically look to address transfer pricing/482

issues using:

▫ Forced combination ▫ Income/expense adjustments or reattribution ▫ Adjustments to pricing on cross-border transactions (separate from IRS position) ▫ Addback of related-party expenses ▫ Disguised transfer pricing adjustments

14

Overview of S tate Landscape (cont.)

• Generally, states see that there are growing issues

related to transfer pricing at the state level – but many lack the resources and knowledge to staff the function.

• MTC has been working to develop a program to

support the states in dealing with transfer pricing issues.

• Contract audit firms also have an increasingly

significant presence in this area.

15

MTC S ITAS

• The Multistate Tax Commission (MTC) has an on-going

initiative called the State Intercompany Transactions Advisory Service (or SITAS), which was established to train individual states, provide a forum for multistate audits, and otherwise assist in enforcing state statutory IRC § 482-type authority.

• The MTC and its member states are working with

RoyaltyStat LLC, the company formed by Dr. Ednaldo Silva (one of the drafters of the IRC § 482 regulations) to implement their audit programs.

▫ Silva is known to have contracted with states directly in addition to his work for the MTC.

16

MTC S ITAS (cont.)

• The following states have participated in the MTC

SITAS process since the inaugural meeting in 2014:

Alabama Indiana Mississippi Connecticut Iowa Missouri District of Columbia Kentucky New Jersey Florida Louisiana North Carolina Georgia Massachusetts Oregon Hawaii Minnesota Pennsylvania

17

Contract Auditors! Oh My…

• While some states are administering their own transfer

pricing audit assessments, many are beginning to rely on third-party audit firms to either manage (or advise behind the scenes) on domestic transfer pricing issues.

▫ For example, Chainbridge Software LLC (who has held contracts with Alabama, DC and New Jersey) continues to shop their software tool to states.

• There is a growing list of audit firms working to get hired

by the states to do transfer pricing audit work.

▫ These firms include (among others) Economic Analysis Group LLP, Economists Inc., NERA Economic Consulting, Peters Advisors LLC, RoyaltyStat LLC and WTP Advisors.

18

Contract Auditors! Oh My… (cont.)

• Third-party contingency fee audit/analysis

arrangements on the horizon?

▫ Mississippi DOR snuck language into 2017 legislation (SB 2973) authorizing the DOR to award contracts on a contingency-fee basis and appropriating up to $1M for FYE 06/30/2018.

• RFP services listed included: providing audit leads,

performing audit and legal analysis, drafting IDRs, preparing formal transfer pricing reports, providing expert witnesses, and training DOR employees.

• We understand that this contract was awarded to

Economic Analysis Group LLP.

19

Recent Developments

• D.C. Chainbridge Litigation
• Microsoft (OAH 2012) – Chainbridge Software LLC

method used by Office of Tax and Revenue to issue assessment was arbitrary, capricious, and unreasonable.

• Shell, Exxon and Hess – same Chainbridge issue.
• Went up to D.C. Court of Appeals on collateral

estoppel issue; remanded to OAH earlier this year.

• Briefing on summary judgment concluded in fall

2017; OAH decision expected early 2018.

• Siem ens, Ahold, AT&T, Eli Lilly, Pfizer, Honeyw ell all

stayed in OAH pending outcome of current litigation.

20

Recent Developments

• See’s Ca nd ies, Inc. v . Uta h Sta te Ta x Com m ’n
• State taxing agency uses its IRC § 482 authority to make

deduction adjustments. ▫ October 2016 – Utah district court upheld 90 percent of the deductions for royalty payments made by a taxpayer to a related party for the use of intellectual property.

 Rejected an argument by the State Tax Commission that the statute gave it unfettered authority to reallocate income upon a finding of distortion of income for tax purposes.  Held that the Tax Commission’s discretion is limited by language outside the statute (i.e., the § 482 regulations).

▫ On appeal before Utah Supreme Court.

 Utah AG and MTC filed briefs urging reversal in May 2017.

21

Recent Developments

• Colorado Court of Appeals Cases
• Oracle Corp. v. Colo. Dep’t of Revenue, 2017 COA 152

(Nov. 30, 2017).

▫ Court of Appeals held that a corporation was not required to include a domestic subsidiary holding company (with no property or payroll) in its Colorado combined corporate income tax returns because the subsidiary was not “includible” under Colorado’s combined reporting regime. ▫ Department cannot rely on its 482-type statute to include the subsidiary or otherwise tax a portion of its income.

• See also Agilent Techs., Inc. v. Colo. Dep’t of Revenue,

2017 COA 137 (Nov. 2, 2017) (same holding).

22

Key Differences – S tate v. Federal

• State taxable income calculation

▫ Addbacks of certain related party payments, adjust apportionment, assert nexus, etc.) ▫ Consolidation rules

• Double tax relief

▫ Cross-border double tax issues can be resolved through competent authority procedures or advanced pricing agreement

• Technical experience

▫ Contract auditors used at state level, plus overall lack of transfer pricing expertise at state level

23

S tate Transfer Pricing Considerations

• Determine the relative functions performed, risks assumed and

assets employed by the respective related taxpayers.

• Review intercompany agreements and course of conduct to

accurately identify and isolate intercompany transactions. ▫ This can be time consuming, but documentation is key.

• Ensure that domestic intercompany policies and agreements align

with current business operations

• Maintain appropriate transfer pricing documentation and monitor

intercompany transaction results annually ▫ Select best method to test the results of intercompany transactions ▫ Review comparables to calculate an arm’s length range of results ▫ Compare the taxpayers’ actual results to calculated arm’s length range

24

S tate Tax Controversy Considerations

• Under what legal authority is the state taxing authority proposing an

adjustment?

▫ IRC §482 equivalent statute? ▫ Addback statute? ▫ Discretionary adjustment authority?

• Is the state’s statute identical to, similar to, or directly references

IRC §482?

▫ If not, what is the standard for an adjustment or assessment? ▫ Arm’s length price? ▫ Fair price? ▫ Clear reflection of income?

• If the statute permits a state taxing authority to act, what types of

adjustment does the statute permit?

• What are the opportunities for settlement?

25

Questions? Comments?

Diann L. Sm ith

McDermott Will & Emery LLP Washington, DC (202) 756-8241 dlsmith@mwe.com

Ellen J. Bloch

GBQ Partners LLC Columbus, OH (614) 947-5278 EBloch@gbq.com

26