Utah Supreme Court Upholds Taxpayer’s Transfer Pricing in Related-Party Transaction

States may have the authority to adjust related-party payments, but only after determining that the transactions are not at arm’s length under federal transfer pricing principles.

Transfer pricing issues don’t just arise in international transactions; they arise across state lines as well.  Transfer pricing rules give taxing jurisdictions the ability to claw back transactions with related parties when those transactions are not at arm’s length.  For example, assume XYZ Corp. in State A (with an 8 percent corporate income tax rate) hires a 100 percent related corporation ABC Corp. in State B (with no income tax) to provide administrative services, and pays ABC Corp. $200,000.  The state tax result is that XYZ Corp. gets a $200,000 tax deduction worth $16,000, and ABC Corp. has $200,000 but pays no income tax.  In that case, what’s to stop XYZ Corp. from paying $1,000,000 to ABC Corp and receiving an $80,000 tax benefit?  The answer is state transfer pricing rules, which are not designed to eliminate the tax result of the transaction entirely, rather only to ensure that the tax result of the transaction is no more favorable than that of unrelated parties.

State transfer pricing rules and the application of those rules may differ, including with respect to the degree to which the state incorporates the federal transfer pricing concepts under Internal Revenue Code (“IRC”) § 482.  On Oct. 5, 2018, the Supreme Court of Utah issued an opinion in which it upheld a taxpayer’s deductions for royalty payments made to a related party, ruling that the state’s discretionary reallocation statute could not be imposed in cases where the transaction met transfer pricing arm’s length standards under federal income tax law principles.[1]

In this case, See’s Candies, Inc. (“See’s”) sold its intellectual property to Columbia Insurance Company (“Columbia”), a related party, in exchange for shares of Columbia’s stock. Subsequent to this sale, See’s licensed the intellectual property from Columbia and paid royalties for its use. As an insurance company, Columbia was not subject to Utah corporate franchise (income) tax, so this transaction effectively served to shift income from a taxable entity to one that is not.[2]

The Utah State Tax Commission attempted to disallow See’s deduction related to these royalties, referring to the state statute that authorizes it to distribute, apportion, or allocate income or deductions among related corporations if it determines such action is necessary to clearly reflect their income.[3]

See’s challenged this action in district court, arguing that the Utah statute should be interpreted in the same manner as its foundation in federal tax law, IRC § 482, which was designed to ensure transactions between related parties were performed at arm’s length. This interpretation would only permit the state to reallocate the deductions in situations where the terms of the related-party transaction were more favorable than those that two unrelated parties would reach. In support of its assertion that the arm’s-length requirements of IRC § 482 were met, See’s provided a transfer pricing study that concluded the terms of the transaction reflected terms that would have been reached between unrelated parties, and it introduced expert testimony supporting the valid business purpose of the transaction.

The district court concluded that the Utah statute was unclear as to when the Utah tax commission could make such an adjustment, in that it was ambiguous as to when action by the commissioner is “necessary to clearly reflect income.” Given this ambiguity, the Court looked to the legislative history to determine the intent of the law. The Court determined that the similarity between IRC § 482 and the Utah statute suggested that the legislature intended that federal guidance be used to interpret the Utah law.  That evidence supported that See’s transaction with Columbia was at arm’s length. When evaluating the Utah tax commission’s appeal of this decision, the Court upheld the district court’s ruling, siding with the taxpayer.

It is worth noting that most states have similar statutes modeled after IRC § 482 that provide the tax authorities broad authority for reallocating income and deductions among related taxpayers, but the specific application and interpretation of transfer pricing methods may differ. Some state income tax codes also have add-back statutes that require, in certain situations, the payor to add-back certain federally-deductible payments made to related parties.

Aprio’s SALT practice has experience dealing with related-party transactions and can assist with understanding the state income tax implications as well as preparing the transfer pricing documentation to support the state income tax impact of these transactions. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the November/December 2018 SALT Newsletter.

[1] Utah State Tax Commission v. See’s Candies, Inc., No. 20160910, (Utah Sup. Ct., October 5, 2018).

[2] Many states, including Utah, require related corporations operating a unitary business to file a single, combined tax report to mitigate any shifting of income between entities. States often exclude from combined reports corporations in specialized industries such as insurance, telecommunications, and transportation. In this case, Columbia was not required to participate in the combined report since it was an insurance company.

[3] UT Code Ann. §59-7-113.  Note the language in this statue is very similar to that of IRC § 482.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

Send this to a friend