Transfer Pricing Studies: Not Just for International Taxpayers

Taxpayers should expect state transfer pricing audits to become more frequent and more comprehensive.

The multi-state income tax system is similar to its international counterpart in that a taxpayer operating in multiple jurisdictions must address issues such as: (1) to which jurisdictions it is required to pay tax (a concept known as nexus in the state tax area) and (2) how much income is sourced to each of those jurisdictions (a concept known as allocation and apportionment). The principal document governing the interactions among countries is a tax treaty, whereas among the states it is the U.S. Constitution (as ultimately interpreted by the judicial system).

Given the similarity of issues, it comes as no surprise that one of the main issues states face in income tax enforcement is base erosion and profit shifting (BEPS). BEPS generally refers to the practice of engaging in intercompany transactions that are priced to generate higher profit in jurisdictions with favorable tax rates and lower profit in unfavorable jurisdictions.

BEPS is nothing new to states. For example, back in the 1990s and early 2000s, many taxpayers created subsidiaries that were domiciled in states with favorable tax rules (e.g., Delaware and Nevada) to hold intellectual property, such as trademarks. The trademarks were licensed to the operating affiliates that paid a royalty to the subsidiary. The result was that the subsidiary generated profits from royalty income that largely went untaxed, and the operating affiliates reduced their taxable income (by the royalty expense) in the states in which such affiliates filed income tax returns.

Some states have been very successful in attacking those structures by applying principles such as economic nexus – arguing that the subsidiary has nexus in the operating states through its licensing of trademarks – and sham transaction/lack of economic substance – essentially collapsing the structure. Other states have enacted mandatory combined reporting, which eliminates the intercompany royalty payment, and many states have enacted add-back statutes, which require the operating affiliates to add back to its tax base the deduction for the royalty payment made to the subsidiary. While almost all states have rules either incorporating directly the federal transfer pricing adjustments under section 482 of the Internal Revenue Code or providing the state with authority to make adjustments to a taxpayer’s income pursuant to transfer pricing principles similar to section 482, states have rarely utilized such authority under audit, mainly due to a lack of training and expertise by state revenue agents. However, that is all likely to change during the next couple of years.

On May 7, 2015, the Multistate Tax Commission (MTC) Executive Committee voted to approve the final design of the Arm’s Length Adjustment Services (ALAS) program. [1] The program sets forth two broad components for correcting improper profit shifting. The first involves “using advanced economic and technical expertise to produce analyses of taxpayer-provided transfer pricing studies and, where appropriate, recommend alternatives to taxpayer positions taken based on those studies.” The second component involves enhancing the ability of states to use this expertise to address profit shifting through related party transactions. This includes training staff at state revenue departments, establishing information exchanges, expanding transfer pricing audit coverage and providing assistance to states in developing, resolving, and defending transfer pricing cases.

The ALAS program has an initial charter period of four years beginning in July 2015. Presently, six states have signed on to participate in the program: Alabama, Iowa, Kentucky, New Jersey, North Carolina and Pennsylvania. However, with a reported $110 million in potential tax revenue to be generated by the ALAS program over the initial charter period, more states are likely to participate.


Taxpayers should expect state transfer pricing audits to become more frequent and more comprehensive. In preparation for this, taxpayers need to review all intercompany transactions (e.g., shared service arrangements – management, treasury, employee leasing, etc. – sales of property, real property leases, intangible property licenses, etc.). All such transactions should be properly documented through intercompany agreements, and all transfer pricing studies should be up to date. If a study has never been performed, taxpayers should perform a transfer pricing study as soon as possible, and HA&W can assist taxpayers with updating and/or performing a transfer pricing study.

Contact Jeff Glickman, partner-in-charge of HA&W’s SALT practice, at for more information.

[1] The MTC is an intergovernmental agency working on behalf of states and taxpayers to administer, equitably and efficiently, the tax laws that apply to multi-state and multinational enterprises. For a copy of the ALAS program, click here.

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