The Challenges of State Transfer Pricing

By Kathryn E. Rice, CPA, MBA, Indianapolis, IN

Transfer pricing is a mechanism used to establish the pricing of various intercompany transactions (i.e., transfers of tangible and intangible property, services, loans, and guarantees) within a multinational or multistate organization. Companies often enter into such transactions with related parties that cross geographic boundaries, and the transfer price used will affect the allocation of the total profit among the different parts of the company. As a result, taxing authorities are inclined to heavily scrutinize those transactions to ensure that a company’s revenues and expenses are properly allocated to a particular jurisdiction or legal entity.

In practice, multijurisdictional organizations are obligated to use an external market price test called arm’s-length pricing when they price internally for tax purposes. In the United States, federal and state taxing authorities have discretionary power to challenge intercompany transactions by readjusting items of income and deductions to clearly reflect taxable income. These powers are authorized at the federal level by Sec. 482. Although most states have not explicitly adopted Sec. 482, they have granted similar powers to varying degrees to their taxing authorities (see, e.g., CT Gen. Stat. §§12-213(a), 12-226(a), 12-225(a), and (b)(1); MA Gen. Laws ch. 63, §§30.4, 33; NJ Rev. Stat. §§54:10A-4(k), 54:10A-10; NY Tax Law §208.9(i); OH Rev. Code. Ann. §§5733.04(l), 5733.031(C); 72 PA Stat. Ann. §7401(3)1(a)).

Recently many states have been taking aggressive steps and becoming more sophisticated in challenging intercompany pricing. There have been significant differences, however, in how they have done so (e.g., forcing combined returns versus disallowing deductions). As a result of such differences, disputes inevitably arise given particular taxing authorities’ different interests, which arise from the bases on which state taxes are levied. While there are several possible avenues a state may choose to take, many of these challenges will involve imposing mandatory combined reporting, making Sec. 482–type adjustments, disallowing tax-motivated or sham transactions, or applying economic and affiliate nexus standards.

Mandatory Combined Reporting

One of the responses to transfer pricing disputes that has been growing in popularity among the states has been to require combined reporting for groups of affiliated companies. In essence, combined reporting (also referred to as unitary filing) is a method whereby states require corporate income tax reporting on total organizational income. Each state attempts to divvy up income based on a formula that apportions total organizational income by using either in-state sales divided by total sales, in-state property divided by total property, in-state payroll divided by total payroll, or some combination of these three factors. When a business is unitary, the fact that the group consists of separate legal entities is generally ignored, and arguably the issue of transfer pricing disappears. The main difficulty that companies face is determining whether a business is unitary given that definitions of what constitutes a unitary business vary based on state statute, regulation, and case law. It can be difficult to determine which entities must be included in a unitary group because the rules may vary from state to state and may also be different from the consolidated reporting status for federal tax purposes.

Some states have adopted water’s-edge combined reporting while others have adopted worldwide reporting, though most of those states will allow the taxpayer to elect which method to use. A worldwide combination includes all members of a unitary business group, regardless of the country in which the member is incorporated or in which the member conducts business. A water’s-edge combination includes all members of the unitary business group except for certain unitary group members that are incorporated in a foreign country and/or conduct most of their business abroad. A common approach under water’s edge is to exclude 80-20 corporations, whose business activity outside the United States as measured by some combination of apportionment factors is 80% or more of the corporation’s total business activity. Other considerations to combined reporting that vary from state to state include, but are not limited to, sales factor throwbacks, nexus considerations, and use of the unitary group’s tax attributes, such as net operating losses (NOLs) and tax credit carryforwards.

Over the years, combined reporting has seen a great deal of controversy from a constitutional standpoint as well as a fairness standpoint—i.e., whether such a method is any more reliable or “fair” than separate return filing because it may less accurately reflect the economic activity that occurs in a specific state. While California began routinely applying the unitary tax in the 1970s, other states have repealed or refused to enact unitary tax legislation in the past. Nonetheless, mandatory combination has now begun to gain broader acceptance. Prior to 2004, 16 states had enacted mandatory combined reporting, with certain other states possessing discretionary authority to require combined reporting under certain circumstances. Currently seven additional states and the District of Columbia have combined reporting legislation, including Massachusetts, Michigan, New York, Texas, Vermont, West Virginia, and Wisconsin. Legislatures in other states have considered adopting mandatory combined reporting but have not yet passed any legislation. Some examples of these include Alabama, Connecticut, Florida, Iowa, Louisiana, Maryland, Missouri, New Mexico, Rhode Island, and Tennessee.

State Sec. 482–Type Adjustments

State Sec. 482–type powers are very broad and discretionary, and state tax authorities most often exercise these powers on audit. Many states have given their tax authorities the power to adjust the pricing of intercompany transactions through statutes or regulations similar to Sec. 482. Other state statutes provide discretionary authority to recompute the tax liability of related corporations when the tax authority determines that a distortion (i.e., distortion of activities, business, income, or capital in a particular state) is present (see, e.g., GA Code. Ann. §48-7-58; NC Gen. Stat. §105-130.16).

In other areas, some states simply disallow certain intercompany expenses and exclude certain intercompany income. Such provisions avoid the jurisdictional issues associated with an economic nexus challenge. For example, in 1991 Ohio disallowed certain interest expenses and intangible expenses, such as license fees and royalties paid. In 1999 it broadened these provisions to disallow direct and indirect costs, as well as losses from factoring and discounting transactions. Ohio’s anti–passive investment company legislation has served as the model for comparable legislation in numerous other states (AL 2001 Special Session, H.B. 2; CT S.B. 416, adopted 1998, §20; MA Senate Bill 1949, §17, adopted 2003; MS H.B. 1695, enacted 2001; NJ Assembly Bill 2501, enacted 2003; NC House Bill 1157, enacted 2001).

Arm’s-length pricing, among other things, can be critical when defending against state challenges on principles such as distortion. State tax authorities have a much more difficult time with those attacks if the intercompany transactions are priced at arm’s length and are properly documented. For example, prior to becoming (arguably) a mandatory combined state, in two cases in New York taxpayers successfully used transfer pricing studies to rebut the presumption of distortion and defeat efforts to force a combination. In both cases, the taxpayer’s transfer pricing study supported its claim that it used arm’s-length pricing (see In re Hallmark Marketing Corp., DTA No. 819956 (N.Y. Div. Tax App. Trib. 7/19/07), and The Talbots, Inc., DTA No. 820168 (N.Y. Div. Tax App. 3/22/07). However, in the Talbots decision, a combined report was ultimately required because the intercompany royalty arrangement was deemed to lack economic substance and business purpose.

Tax-Motivated or Sham Transactions

Many states have also adopted a hybrid approach, combining a Sec. 482 analysis with a business purpose and economic substance analysis. States will often look for ways to make Sec. 482–type adjustments by arguing that transactions lack a business purpose or are shams. Proper planning and preparation of contemporaneous transfer pricing studies in advance is very important to fend off these types of challenges, among others. For example, in Carpenter Tech. Corp. v. Connecticut Dept. of Rev. Servs., 772 A.2d 593 (Conn. 2001), the Department of Revenue Services (DRS) could not disallow a parent corporation an interest deduction on loans made to it by a wholly owned subsidiary because the taxpayer exhibited economic substance, business purpose, commercially acceptable rates, and a proper and accurate reflection of income (see CT Gen. Stat. §12-226(a)). Connecticut has issued regulations that provide the DRS with broad authority to make Sec. 482–type adjustments, which taxpayers have tested numerous times in litigation.

Transfer pricing studies, however, will not completely protect the taxpayer from state challenges if certain factors are not in place. For example, Massachusetts has a series of cases contesting its Sec. 482 authority in which “the net income of a domestic business corporation which is a subsidiary or [closely affiliated entity] shall be determined by eliminating all payments to the parent corporation [or affiliates] in excess of fair value, and by including fair compensation . . . for all commodities sold to or services performed for the parent corporation [or affiliates]” (former MA Gen. Laws ch. 63, §33). In Syms Corp. v. Massachusetts Comm’r of Rev., 765 N.E.2d 758 (Mass. 2002), the court disallowed a deduction for royalties paid for the use of certain trademarks by a parent corporation to its Delaware subsidiary. The court found that the sale and leaseback of the trademarks between the companies lacked economic substance and had no practical effect other than the creation of tax benefits because the subsidiary had added no value to the trademarks, trade names, and service marks.

In TJX Companies Inc. v. Massachusetts Comm’r of Rev., No. 07-P-1570 (Mass. App. Ct. 4/3/09), the court likewise determined that the taxpayer could not deduct royalties paid to subsidiaries for the use of trademarks and other intangibles because there was no business purpose for transferring the trademarks and intangibles to the subsidiary and the transaction lacked economic substance. However, in The Sherwin-Williams Co. v. Massachusetts Comm’r of Rev., 778 N.E.2d 504 (Mass. 2002), the court determined that the taxpayer’s transfer and license-back transactions were not shams and had economic substance. Therefore, the court held that the taxpayer had properly deducted the royalty expenses related to the transactions as business expenses.

Economic Nexus and Affiliate Nexus Standards

Nexus standards found in the Due Process and Commerce clauses of the U.S. Constitution limit a state’s ability to impose taxes on a multistate business. In 1992, the U.S. Supreme Court held in Quill Corp. v. North Dakota Tax Comm’r, 504 U.S. 298 (1992), that nexus requires some form of physical presence in the taxing state. However, many state courts have concluded that the holding in Quill is limited to sales and use taxes. The original income tax case that limited the Quill holding is Geoffrey Inc. v. South Carolina Tax Comm’n, 437 S.E.2d 13 (S.C. 1993), in which the court found nexus by virtue of the intangible property (trademarks) owned by a Delaware holding company that was used by an operating affiliate in South Carolina. Today this is a frequently litigated topic, with both taxpayers and states prevailing.

In general, a taxpayer may establish physical presence indirectly through relationships with third parties in the taxing state. Over the last several years, states have aggressively expanded the principle of nexus to include economic nexus and/or nexus via an affiliate operating in the state. Using economic nexus, states assert the right to tax companies that lack a physical presence in the taxing state but are deemed to do business there through the exploitation of the state’s markets (e.g., via the use of intangibles or direct marketing activities such as the internet or mail-order sales). Affiliate or agency nexus involves cases in which a corporation with no physical presence in a taxing state can still be subject to tax through affiliated entities or use of agents.

If a company believes it has nonfiling exposure, voluntary disclosure can provide a significant tax benefit. Voluntary disclosure generally allows a taxpayer to approach a taxing state anonymously through a representative. The taxpayer agrees to file returns and pay back taxes for a limited number of years and to timely file and pay taxes on a going-forward basis. The taxing state agrees to waive unpaid taxes for years prior to the agreement as well as penalties that it could impose. While voluntary disclosure is an option, proper planning and preparation of contemporaneous transfer pricing studies in advance is very important to mitigate the effects of such challenges where appropriate.


In summary, states are more aggressive and have a variety of tools to increase taxes paid (e.g., nexus, unitary group, etc.) or justify adjustments through the use of Sec. 482. Businesses need to take their own Sec. 482–type approach to defend against these aggressive tools or at least demonstrate that they conducted intercompany transactions at arm’s length. Naturally, taxing authorities want to minimize lost tax revenues and will closely scrutinize transfer pricing arrangements to ensure that they comply with the relevant laws of their respective jurisdictions. In light of the increasing state scrutiny of related-party transactions, it is critical for taxpayers using transfer pricing strategies to fully understand the scope of Sec. 482–type and other relevant statutes, legislation, and case law adopted by the states in which they operate.

Editor: Frank J. O’Connell Jr., CPA, Esq.


Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.

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