Under an initiative developed after court losses, the Indiana Department of Revenue will start scrutinizing taxpayer-submitted transfer pricing studies, is contracting with a section 482 expert, and just executed its first formal advance pricing agreement.
There are at least four pieces of news to report regarding the DOR rolling out its broad transfer pricing initiative.
First, the DOR has created a dedicated transfer pricing team within its audit operations.
“This team is comprised of senior corporate income tax auditors who work collaboratively to develop our knowledge, skill and capability in this complex field,” the DOR said in its latest annual report. The team is leading the DOR’s effort “to develop new audit processes, procedures and training,” the report said. All transfer pricing audits will be conducted by this team; also, the DOR is working to develop transfer pricing subject matter experts — through internal and external training programs — and plans to assign one to each of these audits. On audit, the team will be “performing the detailed and complex examination of transfer pricing transactions to make sure they are at ‘arm’s length,’” the annual report said.
That last point segues to another key piece of news: Indiana auditors will be evaluating the validity of a taxpayer’s transfer pricing study and documentation on third-party arrangements to determine compliance with section 482 and its accompanying regulations.
“In those cases where the Taxpayer’s studies are found to conflict with IRC section 482, adjustments will be made to reflect what would have been the results if the study was in compliance with IRC section 482,” according to DOR slides shared during a meeting with the Indiana CPA Society. The DOR laid out in detail six key areas of a transfer pricing study that auditors will be examining for potential problems. Described in more detail later in this article, those areas include the transfer pricing method used by the taxpayer, the pool of comparables chosen, and the profit level indicator selected.
“It is, I would say, a much deeper technical review of those items,” Kyle Simmerman of BGBC Partners LLP and a member of the Indiana CPA Society told Tax Notes in June.
For assistance, the DOR is contracting with economist Ednaldo Silva of RoyaltyStat LLC for both his transfer pricing consulting services and for access to his firm’s database of comparables. The DOR’s dedicated transfer pricing team initiated the effort to bring Silva into the equation. Silva, a former senior economic adviser with the IRS Office of Chief Counsel, was on the team that drafted the final section 482 regs; his firm highlights his role in developing the comparable profits method, the best method rule, and the concept of the comparable profit interval.
Finally, as part of its transfer pricing initiative, the Indiana DOR is also implementing what might be the first formal state APA process in the nation.
Let’s start there.
State APAs
Emily Boesen, the DOR’s chief communications officer, confirmed that the department in April executed its first APA with a corporate taxpayer.
Modeled after the IRS’s program, Indiana’s APA process is available to taxpayers under audit and is offered at no charge. Once the DOR and taxpayer agree on the transfer pricing method and comparables to be used, the prospective agreements generally will cover two audit cycles — that is, six years.
“The first agreement was suggested by a taxpayer,” Boesen said in a June email with Tax Notes. She added that the DOR has yet to execute its second agreement, though discussions are ongoing with taxpayers as audits proceed. “Several have expressed interest, but no particular taxpayer is negotiating an agreement at the moment,” she said.
When asked whether Indiana is the first state to execute a formal APA, Boesen suggested that the answer is no. “From discussions with other states, we know they have go-forward agreements with taxpayers,” she said. “They may not necessarily be called an APA. These agreements will cover how [taxpayers] will report their income to the particular state.”
Experts involved in multistate efforts to address transfer pricing issues elaborated on that distinction.
“We aren’t aware of other states with an APA or APA-like program,” said Greg Matson, executive director of the Multistate Tax Commission. However, Matson said that when the MTC created its arm’s-length adjustment service advisory group half a decade ago, “I had heard, anecdotally, of a large taxpayer working some transfer pricing out with a state in advance, but it was not a formal thing.”
Joe Garrett Jr. of Deloitte Tax LLP echoed Matson in an email with Tax Notes. “The Indiana program may be the first formal/official state transfer pricing APA program,” said Garrett, a former Alabama deputy revenue commissioner who served as the first chair of the MTC advisory group. “That said, other states will entertain and sometimes pursue agreements with taxpayers that address the go-forward treatment of intercompany transactions.”
Garrett added that those agreements are often the product of audit settlements in which the state and the taxpayer agree to abide by the terms of the settlement for future years, assuming no material change to the facts.
Elizabeth Hazzard, director of transfer pricing services for BKD LLP, attended the meeting at DOR headquarters where revenue officials briefed the Indiana CPA Society about its transfer pricing initiative and new APA process.
“With the finalization of the APA program and an anticipated drop in tax revenues received in 2020 due to the COVID-19 pandemic, transfer pricing enforcement is expected to become a priority, and the APA program is an opportunity for taxpayers and the Indiana DOR,” Hazzard said in an email. “The transfer pricing enforcement initiative that the Indiana DOR has put together demonstrates that state tax authorities are placing greater emphasis on more sophisticated tax issues.”
Hazzard said she believes additional states are likely to adopt APA programs similar to Indiana’s process, especially in light of the state’s participation in MTC discussions. In 2016 the Indiana DOR hosted the first transfer pricing case discussions among revenue officials from multiple states. The forum was a result of the MTC advisory group’s efforts, which included developing special transfer pricing information exchange agreements to enable the participating state revenue officials to share taxpayer documents and engage in case discussions.
The DOR indicated in its annual report that Indiana has maintained and expanded this work with other state revenue departments. “Our Transfer Pricing team is currently working with a collaborative group of 13 states to share information regarding transfer pricing to ensure we are using the most up-to-date techniques and processes,” the report said. “They are also performing lessons learned after the completion of each audit to fine-tune our processes, procedures, and training.”
Garrett, meanwhile, praised the Indiana DOR “for formally opening the door allowing companies to pursue agreements that will eliminate the uncertainty that currently accompanies the treatment of intercompany transactions and separate company filings in Indiana and many other states.”
“Of course, real success will be measured by whether the state and taxpayers can navigate the APA process and find enough common ground to enter into these agreements,” Garrett said. He added that state APAs “will likely need to be somewhat different than their federal counterparts to be attractive to taxpayers.”
“State transfer pricing authority overlaps with state authority for other potential intercompany transaction audit adjustments,” Garrett said. “I’m thinking about intangible/interest expense addbacks and economic nexus, to name two. To really be attractive, the state APA will need to address the range of potential intercompany transaction audit issues so a taxpayer can be confident its intercompany transactions will be respected by the taxing authority.”
Tax Court Losses
The next section will go into detail about what the DOR will be looking at in taxpayer-submitted transfer pricing studies. Before that, however, it is worth reviewing what prompted the DOR to try a new approach.
Boesen confirmed that the DOR developed the initiative partly in response to headline-making Indiana Tax Court orders in 2015 granting summary judgment to Rent-A-Center East Inc. and to Columbia Sportswear USA Corp. Both cases involved challenges to DOR adjustments made without regard for or examination of taxpayer-submitted transfer pricing studies.
Indiana is a separate-return filing state. Before 2015, auditors tended to invoke the DOR’s discretionary authority to require a company to file a combined return with affiliates when they determined that intercompany transactions distorted the company’s Indiana-source income as reported separately.
Rent-A-Center East challenged the DOR’s decision to force combination, arguing that its separate return fairly reflected its Indiana-source income. As evidence, Rent-A-Center East submitted a transfer pricing study purporting to show that its royalty and management fee payments to two affiliates were at arm’s-length rates.
The parties stipulated that the DOR had not examined the intercompany transactions at issue on audit or at any other stage of the administrative protest. Instead, the DOR had argued that the separate return did not fairly reflect Rent-A-Center East’s Indiana-source income, which auditors said was substantial but had been reduced to zero after the company deducted the royalty and management fee payments as intercompany business expenses. The DOR had asked the tax court to disregard the transfer pricing study as irrelevant, arguing that “1) it concerns financial accounting, not tax, 2) it concerns federal, not Indiana law, 3) it has no binding effect on state tax authorities, 4) other jurisdictions have rejected similar studies, and 5) it is flawed.”
The Indiana Tax Court found each of those arguments unconvincing. It said that in the summary judgment context, by submitting the transfer pricing study Rent-A-Center East had met its burden of providing “sufficient evidence demonstrating that there is, in actuality, a genuine issue of material fact with respect to the unpaid tax.” The tax court also wrote that none of the designated evidence showed that Rent-A-Center East had engaged in improper tax avoidance, or that its intercompany transactions lacked a valid business purpose or economic substance. The tax court found that the DOR had improperly forced combination, and the court granted summary judgment to Rent-A-Center East.
Three months later, the Indiana Tax Court incorporated Rent-A-Center East in its order granting summary judgment to Columbia Sportswear, which had also submitted a transfer pricing study to challenge DOR adjustments made on audit. Here, too, the DOR had “neither . . . alleged nor provided designated evidence to show that Columbia Sportswear's Transfer Pricing Studies are invalid or unreliable because they failed to comply with IRC section 482 and its related regulations,” the tax court said, and found the DOR’s adjustments to be improper.
The potential implications of the Indiana Tax Court orders became the subject of much focus among state tax officials across the nation. Earlier in 2015 the MTC’s executive committee had approved a design for an arm’s-length adjustment service, which has not been implemented. The idea behind that MTC advisory group effort was for state revenue departments to find a way to collectively finance the hiring of top-flight economic experts to analyze taxpayer-submitted transfer pricing studies and to produce reports supporting state adjustments.
"Cases like Rent-A-Center East in Indiana demonstrate how transfer pricing studies threaten to make the corporate audit programs of separate-entity states essentially obsolete," Matson said at that time. He had added that the proposed arm’s-length adjustment service, which has not been formally implemented, was “all about saving those audit programs from obsolescence."
But not all state revenue officials believed that Indiana’s losses were a sign that separate-entity states ought to back off. Marshall Stranburg, the MTC’s immediate past deputy director and former head of Florida’s revenue department, was among those who said state auditors still had the option of examining with specificity the taxpayer-submitted transfer pricing studies.
That’s exactly what Indiana auditors will be doing.
Transfer Pricing Audits
Practitioners said they had yet to have a client undergo the new transfer pricing process. However, Indiana revenue officials have highlighted for practitioners the following six areas of taxpayer-submitted transfer pricing studies that the DOR considers to be potentially problematic.
Timeliness of comparables information. Specifically, auditors will be looking at the interplay of this information with taxpayer-selected profit level indicators (PLIs), which the DOR slides said “should be derived from a sufficient number of years of data to reasonably measure returns that accrue to uncontrolled comparables.” Citing Treas. reg. section 1.482-5(b)(4), the DOR said the period generally should include the tax year under review and the two preceding years. While the DOR said it would accept an older transfer pricing study, the PLIs for the comparables “must be updated to the appropriate periods.”
Inclusion of companies outside the taxpayer’s geographic area. Citing Treas. reg. section 1.482-1(d)(4)(ii), the DOR indicated that auditors will be excluding from a transfer pricing study’s pool of comparables those companies outside the taxpayer’s geographic region, including Canadian companies.
Inclusion of loss companies. Auditors also will be removing loss companies from a taxpayer’s pool of comparables. The slides seemed to indicate that the DOR’s reasoning is based on the assertion that comparability under the comparable profits method “is highly dependent on risks assumed,” and that an operating profit is suggestive of a company’s assumption of risks as well as its investment of resources. “Most studies will take the position that the Indiana Taxpayer has little or no risk,” the DOR said. “Loss companies, especially those under chronic financial distress, indicate a level of risk that is not comparable to low risk companies as represented in the typical transfer pricing study.”
Inappropriate adjustments. Auditors will be looking closely at adjustments in a transfer pricing study “that reduce the PLIs of comparables with little theoretical support.” The DOR said it will be making adjustments in accordance with Treas. reg. section 1.482-1(d)(2)’s standard of comparability when differences between the tested party and an uncontrolled comparable “would materially affect the profits determined under the relevant profit level indicator.” Examples of adjustments addressed in the Treasury regs “include stock based compensation, [last-in, first-out] accounting, [and] characterization of income in databases as operating or non-operating income,” the slides said.
Use of methods comparing uncontrolled transactions to the controlled transactions under review. This would include a transfer pricing study’s use of the comparable uncontrolled price method, the comparable uncontrolled transaction method, or the comparable uncontrolled services price method. “Where uncontrolled transactions that are the same, or highly similar, to the controlled transaction under review, this will be the best method,” the DOR said. “Where the transactions are materially different and no reliable adjustments can be made, DOR will reject the attempted use of this method.”
Choice of PLI. According to the slides, whether a taxpayer’s choice of PLI is appropriate will depend on several factors, including the nature of the activities of the tested party, the reliability of the available data regarding uncontrolled comparables, and the extent to which the PLI “is likely to produce a reliable measure of the income that the tested party would have earned had it dealt with controlled taxpayers at arm’s length, taking into account all of the facts and circumstances.” Auditors will be rejecting a PLI that has a denominator reflecting controlled transactions. “For technical reasons, the denominator in the PLI’s definition generally should be an item that does not reflect controlled transactions,” the DOR said.
Will It Work?
Garrett said that while Indiana’s initiative “seems a reasonable response to the tax court decisions, formal transfer pricing is not easy.”
“Success is going to require a significant commitment and openness to finding that common ground,” Garrett said.
Simmerman suggested that the relationship between the DOR and tax practitioners might be strong enough to make that that happen. The DOR's slides are from a December 2019 briefing by revenue officials to the Tax Resource Advisory Council of the Indiana CPA Society.
“They laid this out really well,” said Simmerman, a longtime member and former chair of the advisory council. “Certainly, they’ve been very transparent with us as the process is being developed.”
According to Simmerman, practitioners in late 2018 first learned from revenue officials about the DOR’s transfer pricing initiative. The advisory council meets about three times a year with DOR officials “on very specific items and opportunities to work together,” Simmerman said, and asked that revenue officials brief practitioners about the new approach.
“We have very open communication with them about systematic issues we’re seeing with the department, and they are very open with us about any issues or initiatives they have,” Simmerman said. “This is another example of where that collaboration has been really meaningful.”