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State Transfer Pricing Trends and Opportunities Accelerated by COVID-19

Posted on Nov. 16, 2020

Shirley Sicilian (ssicilian@kpmg.com) is a managing director in the state and local tax group of the Washington National Tax practice of KPMG LLP and serves as the firm’s national director for SALT controversy; Stephen Snyder (stephensnyder@kpmg.com) is a director with the economic and valuation services group of KPMG’s Atlanta tax practice; and Nikki Bossert (nbossert@kpmg.com) is a senior associate in the SALT group of the Washington National Tax practice of KPMG.

In this article, Sicilian, Snyder, and Bossert discuss recent state transfer pricing trends and how they have been affected by the COVID-19 pandemic.

The following information is not intended to be written advice concerning one or more federal tax matters subject to the requirements of section 10.37(a)(2) of Treasury Circular 230. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG.

When the coronavirus pandemic first took hold in the states, most revenue agencies focused initially on the immediate need for operational and procedural relief. Their first-tier issues included conformity with the federal compliance filing and payment deadlines. Ultimately, 49 states extended deadlines or offered interest/penalty relief for at least one major tax type, mostly income and some sales.1 States then turned to other process issues, which included the practical difficulties of meeting deadlines and physical filing requirements for basically everything else: from audits and refund claims through protests and hearings. Over two-thirds of the states addressed these process issues. Many states even addressed some substantive issues, such as whether employees who are now working from home in a state will create nexus or disrupt P.L. 86-272 protections in that state for their employers. As state agencies have adapted to working from home, and some states have begun to reopen for general business, we’re now seeing these deadline extensions and process workarounds terminate or be allowed to expire.2

Deeper-rooted fiscal issues remain, however. State fiscal pressures because of COVID-19 are expected to continue at least through fiscal 2021. These fiscal pressures will affect audit and appeal activity, and may accelerate state transfer pricing trends, including opportunities for early resolution.

State Fiscal Situation

Most states closed out their 2020 fiscal years on June 30 with total tax revenue down sharply from the prior year, marking the first decline in state tax revenue since the Great Recession of fiscal 2009-2010.3 The largest impact was in personal income tax, which had a 10 percent decline and represents 36.2 percent of total state taxes. Corporate income taxes showed the next-largest decline, at 17.5 percent, but this was not nearly as impactful because corporate income tax makes up less than 5 percent of total state taxes. Although these declines certainly reflect economic conditions, they were also significantly driven by the decision in many states to extend income tax payment deadlines from the final quarter of fiscal 2020 to the first quarter of fiscal 2021.4

Table 1. State Tax Revenue Declines by Tax Type — FY 2020 Over FY 2019

Tax Type

Percentage Change in State Tax Revenue FY2020/FY2019

FY 2020

Percent of Total State Tax Revenue

Sales

-0.5%

40%

Personal Income

-10%

36.2%

Corporate Income

-17.5%

4.7%

Property

2%

1.8%

All Other

-3.7%

17.3%

Total

-5.5%

100%

Source: U.S. Census Bureau, “Quarterly Summary of State & Local Tax Revenue Tables.”

The following chart helps put all this in a longer-term perspective. It shows that the percentage rate of growth in total state taxes on a year-over-year basis from 2011, just after the Great Recession, through 2019, has averaged a positive 5 percent. During the recession, we saw year-to-year decreases of negative 8.2 percent in fiscal 2009, and then a negative 2.2 percent in fiscal 2010. At the start of the pandemic, in March 2020, fiscal 2020 was trending at a positive 6.9 percent growth over the same period for fiscal 2019, but by the end of fiscal 2020, that growth was wiped out, with the year ending at a negative 5.5 percent.5

Even with the shift in tax collections from fiscal 2020 to fiscal 2021, as noted above, state fiscal positions are expected to degrade further through fiscal 2021. According to the National Association of State Budget Officers, declines in fiscal 2021 state tax collections because of the pandemic are expected to exceed the drop states experienced during the recession, with some states anticipating declines of more than 20 percent.6 Although federal funds could provide some relief, there is no guarantee that funds for state governments will be part of future stimulus legislation. And even if states do receive federal funding, it is not expected to be enough to overcome the shortfall in tax collections.7

Yet state constitutions generally require a balanced budget each fiscal year. Many governors have directed agencies to develop contingency plans for reduced budgets in fiscal 2021 and even fiscal 2022 by as much as 15 to 20 percent8 and we have already begun to see state spending cuts, including furloughed state workers. As more state legislatures convene in January 2021, we may also see increased taxes, general or targeted amnesties, or reduced tax benefits, like net operating loss caps and carryforward limitations.

Figure 1.

Impact on Audit and Appeal

In the early days of COVID-19, many states put new audits and assessments on hold. There could be a backlog, and given the fiscal situation, there may be a flurry of activity to get it worked through. When all this kicks back up, what should we expect? There are two schools of thought — both valid. One is that state audit positions may become more aggressive. But aggressive positions can turn a two-year audit into a five-year audit, and that may not be what states are interested in right now. The other school of thought is that we may see an increased state focus on resolution. Taxpayers that do want to resolve a matter may benefit by pulling together solid support for a proposal and identifying it to the state as something that could be wrapped up quickly. Some thought could be given to expanding the scope of resolution to include future tax years (in states that have that authority), other tax types, or simplified process agreements. Also, it would not be correct to assume states will uniformly resist refund requests. Some states, for example, New Mexico, have recognized that taxpayers are experiencing serious economic impacts as well, and said they will be prioritizing review and approval of refund requests and business credits.9

Although one might not expect future audits to be particularly aggressive, it would not be surprising to see increased audit activity, with increasingly novel issues, and therefore more need for protest and appeal. This had been expected even before COVID-19 because there is just an awful lot of new state laws. Of course, states are always enacting new laws, but in recent years there has been an unusual amount of disruption nationally — with Wayfair creating a wave of sales tax economic nexus and marketplace facilitator laws, federal tax reform conformity (or not), and now pandemic-related tax legislation at the federal and state level. New laws bring new interpretational uncertainties and a need to resolve it all somehow. We may see more state amnesty, early resolution programs, and other alternative dispute resolution processes.

State Transfer Pricing Resolution Opportunities May Emerge

Transfer pricing is another rapidly developing area of state law. It is a complex subject regarding both the method for determining an appropriate price and the extent of state authority to make an adjustment.10 Both taxpayers and tax agencies may have something to gain if they can avoid expending limited resources on drawn-out litigation of these complex issues.

Traditionally, many states lacked in-house expertise or access to the training necessary to do much with transfer pricing on audit. But that is changing. Several states have made significant and continuing efforts to professionalize their transfer pricing audit capabilities since at least 2014, when New Jersey tax administrators asked the Multistate Tax Commission to create a group for that purpose. The MTC ultimately formed the State Intercompany Transactions Advisory Service (SITAS) Committee. SITAS members have included tax agency representatives from Alabama, Florida, Georgia, Indiana, Kentucky, Louisiana, Mississippi, Missouri, New Jersey, North Carolina, Pennsylvania, and South Carolina, among others.11 To enhance collaboration, each state signs a participation commitment and exchange of information agreement. While statutes generally authorize a state tax agency to share confidential taxpayer information with other state tax agencies, this agreement establishes the manner in which exchanges will take place among the signatory states specifically for transfer pricing information.12 Naturally, any work by the signatory states that involves this confidential information will be conducted outside the public eye. So the lack of public meetings should not be misread to mean the work is not being conducted at all. The SITAS Committee’s 2020 annual report was just one paragraph, but in that one paragraph the MTC let us know that it “continues to encourage discussions among Committee member states, and other states pursuant to other information exchange agreements and authorizations.”13

As we would expect, most of the committee members are from separate reporting states. But a handful are from combined reporting states, as states that recently adopted combination may still have tax years open under the separate reporting regime. Combined reporting states may still have transfer pricing concerns whenever the transacting affiliate is outside the combined group; for example, a captive insurance company or a foreign affiliate outside the water’s edge.

Of course, both separate and combined reporting states may have multiple options to address transfer pricing concerns, including addbacks or, especially after Wayfair, asserting tax jurisdiction over the out-of-state seller if its sales are sourced to the state. Some separate reporting states have reacted to transfer pricing concerns by asserting distortion in the apportionment formula and applying combined reporting as a remedy on a case-by-case basis. But as states work to develop their transfer pricing capabilities, they are increasingly addressing concerns more directly, using existing authority under state statutes modeled on IRC section 482.14 Whether through coordination via the MTC or on their own, “[a]t least 23 state revenue departments and the District of Columbia have recently done one or more of the following:

  • contracted with outside experts for transfer pricing services;

  • executed special transfer pricing information exchange agreements, which enable revenue officials from multiple states to share taxpayer documents and engage in case discussions; or

  • sent revenue staff to a national two-day training exclusively focused on instruction on section 482 and transfer pricing.”15

The result has been a greater state audit focus on transfer pricing. In many cases, increasing professionalism in state transfer pricing reviews can be a welcome development that leads to better understanding by states of taxpayers’ support for their positions, more efficient audits, and, in turn, more reasonable and faster resolutions.

One state, North Carolina, recently initiated a voluntary amnesty-type program targeted at clearing out its transfer pricing dispute backlog. The state was focused on resolving disputes around transactions that lack economic substance, or that don’t follow the state’s fair market value standards. The program provided a penalty waiver if the taxpayer was able to resolve its dispute with the state during the stated time frame. Usually these types of voluntary disclosure agreements are for undiscovered taxpayers, but this program was open to taxpayers that had been notified of an upcoming audit, were under audit, or were in the request for review process, as well as taxpayers that hadn’t been contacted. The program included a series of deadlines:

  • By September 15, taxpayers had to agree in writing to participate by emailing an election to participate form to the Department of Revenue’s representative or to the taxpayer’s auditor if the taxpayer was under audit.

  • By October 16, taxpayers had to provide all required documentation to the department. This could include transfer pricing, tax, and financial information.

  • Within 31 days, the department promised to review the relevant documentation and propose an adjustment, which the taxpayer would then have 15 days to accept.16

Based on data disclosed by the DOR, taxpayers were eager for the program — approximately 100 taxpayers elected to participate.17 However, this type of program is not risk free for taxpayers — there is no guarantee when you walk in that you’ll walk out with an acceptable proposal. The proposal could include forced combination, for example. So this wouldn’t necessarily be the best path for an undisclosed entity that has not already been contacted by the department, unless the entity could remain nondisclosed until a deal is reached. However, North Carolina indicated its program would require disclosure before that point in the process.

Another state, Indiana, has also adopted an increased focus in the transfer pricing area. The state’s fiscal 2020 annual report highlights its audit operations team’s work in the area of transfer pricing, referring to a “collaborat[ion] with 13 states to improve compliance, increase tax revenues and develop the specialized audit process for this complex area of tax law.”18 In fact, Indiana has created a new, dedicated transfer pricing unit within the audit division, modeled on the IRS’s advance pricing and mutual agreement program. The Indiana DOR has contracted with a consultant for transfer pricing consulting services and access to a comparables database. Once the department and taxpayer agree on the transfer pricing method and comparables to be used and formalize the advance pricing agreement pricing terms, the prospective agreements generally will cover six years; that is, two audit cycles.19 The DOR reports that it’s already negotiating APAs with several taxpayers.

To be clear though, these state agreements appear to be what would be considered unilateral agreements at the federal level. They are binding only on the signatory state’s tax position regarding that signatory state’s taxpayer. They do not bind any other state regarding the taxpayer, nor do they bind any other state regarding the affiliate on the other end of the transaction. In fact, it is not 100 percent clear at this point whether such agreements would always bind even the signatory state regarding the affiliate on the other end of the transaction if that affiliate were to later become a taxpayer.

While these programs offer hope that states want to reach agreements on transfer pricing methods, one of the main benefits of an APA is that a taxpayer can achieve certainty in its approach on both sides of the intercompany transaction. To accomplish this, more states will need to adopt similar APA programs, or at least be willing to entertain advance resolutions on a case-by-case basis, so that taxpayers aren’t whipsawed on the other side of the transaction. Taxpayers might request use of the MTC’s multistate alternative dispute resolution program as a forum for working out these broader agreements with multiple states.

Closing Observations

The confluence of two trends — declining state revenue and increasing professionalism of state transfer pricing capabilities — could lead states to focus more effort not just on transfer pricing audits, but also on transfer pricing dispute resolution. The programs in Indiana and North Carolina indicate that at least some states are looking for ways to resolve transfer pricing issues in bulk, and we may see more like them. Even some states without defined programs have been willing to attempt resolution on a case-by-case basis.

FOOTNOTES

1 Nevada did not provide any relief for sales tax purposes and the state does not impose an income tax.

2 When these extensions and suspensions terminate or expire, it may essentially set new deadlines for protests, appeals, refund filings, assessments, and so forth, and some may be quite time-sensitive. The nexus and P.L. 86-272 protections could also be affected. To the extent tax teams may have been relying on these extensions and suspensions, the reverse transition, though somewhat less abrupt, should be watched to avoid missed deadlines or failure to comply with reinstituted filing requirements.

3 See Table 1. Most states have a June 30 fiscal year close, but not all do. For example, New York’s fiscal year opens April 1, Texas opens September 1, and Alabama and Michigan open October 1. For fiscal 2021 only, New Jersey opens on October 1. Shelby Kerns, “State Revenues Decline for First Time Since the Great Recession, With the Worst Still to Come,” National Association of State Budget Officers (Sept. 8, 2020).

4 See Kerns, supra note 3 (“Most states extended their tax filing deadlines to conform with the federal government, which resulted in 19 states counting revenue in fiscal 2021 rather than fiscal 2020.”); Urban Institute, “State Tax Revenues Surged in July 2020, but Cumulatively Are Down During COVID-19 Period” (July 2020) (“Total state taxes increased 82.1 percent in July 2020 compared to a year earlier, according to preliminary data from 40 states. Personal income taxes increased 155.1 percent, sales taxes increased 10.7 percent, and corporate income taxes increased 360.2 percent.”).

5 The total of all state taxes collected for the 12-month period as of March 31, 2019, was $1,043,331*, compared with a total of $1,114,854* for the 12-month period ending March 31, 2020. The total state taxes collected for the 12-month period as of June 30, 2019, was $1,076,781*, compared with a total of $1,017,128* for the 12-month period ending June 30, 2020 (*amounts are shown in millions of dollars). U.S. Census Bureau, “Quarterly Summary of State & Local Tax Revenue Tables.”

6 Kerns, supra note 3.

7 See Elizabeth McNichol, Michael Leachman, and Joshuah Marshall, “States Need Significantly More Fiscal Relief to Slow the Emerging Deep Recession,” Center on Budget and Policy Priorities (Apr. 14, 2020); and CBPP, “States Grappling With Hit to Tax Collections” (last updated Nov. 6, 2020).

8 Kerns, supra note 3.

10 See Shirley Sicilian, “Comment Now While Multistate Transfer Pricing Group Forming Proposals,” J. Multistate Tax’n & Incentives (Jan. 2015); see also, e.g., Columbia Sportswear USA Corp. v. Indiana Department of State Revenue, 45 N.E.3d 888 (Ind. T.C. 2015); Utah State Tax Commission v. See’s Candies Inc., 435 P.3d 147 (Utah 2018). Setting a transfer price is a complex subject involving an analysis of accounting, tax, and economics disciplines, especially for large multinational and multijurisdictional companies. For example, a large taxpayer could be involved in intercompany loan, service, tangible, and intangible transactions among multiple jurisdictions. The intent of a transfer pricing analysis is to identify arm’s-length pricing for each intercompany transaction so that the resulting taxable income is equitable, economically supportable, and not distorted.

11 Michael J. Bologna, “States Target Missed Tax Collections From Intercompany Transfers,” Bloomberg Tax, Aug. 13, 2020.

14 See Sicilian, supra note 10 (summary of state adoption of authority based to varying degrees on IRC section 482); see also Sicilian, Sarah McGahan, and Ian Novos, “Transfer Pricing — Collateral Estoppel in the District of Columbia,” J. Multistate Tax’n & Incentives (Mar./Apr. 2015). Federal regulations provide a framework for analyzing methods to determine arm’s-length pricing for intercompany transactions, and the extent to which states are required to follow these federal regulations has been a contentious issue. See, e.g., Columbia Sportswear USA Corp., 45 N.E.3d 888 (Ind. T.C. 2015); and See’s Candies, 435 P.3d 147 (Utah 2018); see also Roxanne Bland, “Transfer Pricing Takes Center Stage,” State Tax Notes, May 2, 2016, p. 365.

15 Amy Hamilton and Andrea Muse, “News Analysis: States Aggressively Contracting With Transfer Pricing Experts,” Tax Notes Federal, Apr. 6, 2020, p. 29.

17 Hamilton, “Participation High in North Carolina Transfer Pricing Initiative,” Tax Notes State, Oct. 5, 2020, p. 85 (“The agency’s most recent report on corporate income and franchise tax statistics and trends data suggests that 100 taxpayers represents a significant level of participation by potentially affected taxpayers.”); see also North Carolina DOR, “Corporation Income and Business Franchise Taxes: Statistics and Trends, Tax Year 2017” (Mar. 2020).

18 Indiana DOR, FY20 Annual Report at 28.

19 Indiana DOR, Advanced Pricing Agreement Program (Sept. 2020); and FY19 Annual Report at 46.

END FOOTNOTES

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