Editor: Greg A. Fairbanks, J.D., LL.M.
Tax professionals do not always recognize the sales and use tax implications of certain transfer-pricing policies implemented for intercompany transactions undertaken between two or more related entities. It is common to determine a single transfer price by aggregating multiple intercompany transactions, which may expose taxpayers to sales and use tax assessments. Based on the multistate sales/use tax rules relating to intercompany transactions, and the real possibility of state and local tax audit examinations, this issue should be considered while implementing transfer-pricing policies that aggregate intercompany transactions.
This discussion first outlines the basics of sales and use tax and transfer pricing, then considers how intercompany transfer pricing may unintentionally lead to sales tax exposure, and concludes with the steps a taxpayer can take to avoid audit assessments and penalties.
Sales and use tax basics
Sales tax is a tax on transactions involvingany sale, transfer, or exchange of tangible personal property and/or certain services to consumers. The complementary use tax is typically imposed on the purchaser (generally at the same rate as sales tax) when a company purchases taxable property/services from a vendor (including non-U.S. vendors) that does not charge sales tax. Tax is generally imposed on taxable sales based on the location where the property is delivered/used by the purchaser and/or where the benefit of the taxable services is received. In contrast to the federal and state corporate income tax regimes, which often eliminate intercompany transactions as a condition of a combined or consolidated filing, the sales and use tax can be imposed on intercompany transactions.
The types of product and service transactions that require the collection of sales/use tax, and the exemptions that may apply to such transactions, are based on the laws of each state. States generally impose tax on receipts from the sale of tangible personal property (though many states have specific use-based exemptions such as equipment used for manufacturing/research-and-development purposes, customer-based exemptions, or sales for resale). A number of states also impose tax on the receipts for the provision of services such as software as a service (SaaS), information/data services, digital goods, repair/maintenance, and telecommunications. On a multistate basis, most professional services (such as legal, accounting, financial, and other similar types of transactions) are exempt from sales/use tax. Some states, including Connecticut, New Mexico, New York, South Dakota, Texas, and Washington have more expansive tax bases than other states.
Because each state operates its own independent sales and use tax regime, and transfers between related parties, including disregarded entities for income tax purposes, may be taxable under the sales and use tax, determining whether a particular transaction is taxable or exempt on a multistate basis is challenging and often leads to nonuniform conclusions.
Transfer pricing refers to the pricing of transactions between enterprises under common ownership or control (referred to as "related party" or "intercompany" transactions). Intercompany transactions include tangible property, intangible property, services, and financing. Transfer-pricing rules and regulations are provided under Sec. 482 of the Internal Revenue Code. Most countries impose their own set of transfer-pricing rules or adopt the transfer-pricing guidelines provided by the Organisation for Economic Co-operation and Development (OECD). Most follow the "arm's-length standard," whereby the price between related parties should be set as if the related parties were dealing with unrelated parties, as addressed in Regs. Sec. 1.482-1(b). Thus, an arm's-length price eliminates the shifting of profits from one country to another by underpricing or overpricing intercompany transactions.
Various methods are available in the regulations under Sec. 482 to arrive at an arm's-length price for tangible property, intangible property, cost sharing, and intercompany services transactions (similar methods are generally available for transactions in foreign countries, under OECD guidelines). One transfer-pricing method commonly used to determine an arm's-length price for tangible property, intangible property, and services transactions is called the comparable-profits method (CPM, under Regs. Sec. 1.482-5, and is known as the transactions-net-margin method under OECD rules). The CPM is a profit-based method that generally aims at arm's-length profitability at an operating income level for intercompany transactions.
Taxpayers' use of a CPM to address multiple transactions on an aggregate basis may lead to unintended sales and use tax ramifications in the United States, especially under state and local tax audits in today's pandemic climate where states are experiencing significant budget deficits. The following section provides an example of the application of the CPM that addresses multiple transactions on an aggregate basis, followed by a discussion of the issue, resulting from the interplay of sales and use tax and transfer pricing.
Application of the transfer-pricing method
The CPM generally targets profitability at an operating income level in the form of operating margin, markup, or other measure. In doing so, remuneration for multiple intercompany transactions (except for intercompany financing transactions) may be aggregated. For example, consider a U.K. parent (U.K. Parent) that manufactures widgets and sells widgets to its U.S. subsidiary (U.S. Sub) for further resale in the United States. In addition, U.K. Parent also provides certain management services to U.S. Sub and incurs certain expenses relating to software that the entire group uses. The company implements a transfer-pricing policy of targeting an operating margin of 5% for U.S. Sub through a CPM, as an arm's-length remuneration for performing distribution functions. Since U.K. Parent is targeting a fixed operating margin for U.S. Sub, U.K. Parent does not charge U.S. Sub separately for each of the intercompany transactions noted above (i.e., tangible goods, management services, and purchasing software on its behalf).
The remuneration for the intercompany transactions may be aggregated in two ways: (1) through the sales price of the widget from U.K. Parent to U.S. Sub or (2) through a management fee if the sales price of the widget is identified separately. Under both scenarios, U.S. Sub will receive a 5% operating margin, and any residual income left with U.S. Sub after targeting a 5% operating margin will be paid to U.K. Parent through a cost-of-goods-sold (COGS) adjustment on U.S. Sub's books in scenario one, or through a management fee in scenario two, noted above.
Intercompany transaction issues in the sales tax context
With this background, it is interesting to see how states have addressed situations in which related parties have engaged in transactions that have sales tax consequences that may not be readily apparent at first blush. A 2016 ruling issued by the Virginia tax commissioner illustrates the need to review intercompany transactions closely when dealing with potential sales tax exposure issues. In that ruling, the parent company was a holding company for various subsidiary companies that performed electrical and telecommunications contract work. The parent purchased equipment that was used interchangeably by the subsidiaries to perform the contract work. The parent paid sales/use tax at the time of purchase. The parent made cost allocations to each subsidiary for that subsidiary's use of the equipment. The cost allocation method employed by the parent was not intended to generate a profit for the parent.
The Virginia Department of Revenue (DOR) audited the parent and assessed sales tax on the amounts representing the cost allocations recorded as journal entries in the parent's books. The DOR then provided a credit to the parent for sales/use tax paid at the time of its purchase. The commissioner noted that, under prior Virginia rulings, the use of intercompany transactions to account for the costs associated with the purchase or lease of tangible personal property constituted consideration. The fact that there was no direct payment of cash, issuance of a note, or other actual exchange of value was determined by the commissioner to be irrelevant (Va. Dep't of Tax, Ruling of the Tax Commissioner, Pub. Doc. 16-84 (5/17/16)).
In Kansas, legislation addresses the sales tax treatment of certain intercompany arrangements. An interdepartmental transfer of tangible personal property or taxable services between different departments of a single legal entity is not considered a sale that would be subject to sales tax (Kan. Admin. Regs. §92-19-72(a)). However, in Kansas (like most states), any transfer of tangible personal property or taxable services between separate legal entities for use or consumption rather than resale is subject to tax, even if the entities share common principals or ownership and operations, share the same business location, file consolidated income tax returns for federal and state income taxes, or do not enjoy a profit or expense as a result of the transaction (Kan. Admin. Regs. §92-19-72(b)).
The Virginia ruling and specific Kansas statutes are good transfer-pricing-related examples confirming that a sales/use tax obligation by either the related parent, subsidiary, or perhaps both could exist, even if no actual "cash" is exchanged. A number of multistate state rulings/cases have demonstrated the critical need to consider the potential sales tax/use tax liabilities that can arise from intercompany transfer-pricing transactions, in myriad fact patterns (La. Dep't of Rev., Informal Advice (Aug. 31, 2004); Va. Dep't of Tax, Ruling of Commissioner, Pub. Doc. 19-82 (Aug. 2, 2019); Okla. Tax Comm'n, Letter Ruling 14-053 (Sept. 10, 2014); N.Y. Dep't of Tax. and Fin., TSB-A-16(4)S (Feb. 22, 2016); Wash. Dep't of Rev., Determination No. 15-0315, 35 WTD 457 (Sept. 30, 2016); Minnesota Made Hockey, Inc. v. Commissioner of Rev., No. 9221-R (Minn. Tax Ct. 7/30/19); but see Department of Rev. v. River City Refuse Removal, Inc., 729 N.W.2d 396 (Wis. 2007), aff'g 712 N.W.2d 351 (Wis. Ct. App. 2006); Ind. Dep't of Rev., Letter of Findings No. 04-20181674 (Nov. 7, 2018); N.J. Div. of Tax., Regulatory Servs. Branch, Informal Advice (Sept. 22, 2004).)
To draw a more general conclusion regarding how states may approach these types of issues, a look back to the earlier example between U.K. Parent and U.S. Sub is in order. The presence of an operating margin developed for U.S. Sub leads to a potential use tax issue. Specifically, U.S. Sub may not realize that it should self-assess a use tax on the use of software that is paid for by U.K. Parent when the residual income is paid by U.S. Sub to U.K. Parent either through a COGS adjustment or management fee, because a separate remuneration was not identified for the use of software. Moreover, in certain states, professional services such as management services may be subject to tax as well. To the extent U.S. Sub (or a similarly situated company) fails to self-assess a use tax on the use of software or the receipt of potentially taxable professional services, a state tax auditor may impose a use tax on the amount higher than the amount attributable to the use of software (or professional services) and may impose significant penalties and interest on the unpaid amount of tax.
Steps to mitigate the sales/use tax issue arising from transfer pricing
Given the potential draconian consequences, a company may consider the following steps to mitigate potential exposure on the sales/use tax and transfer-pricing front:
- In most states, bundling both taxable and nontaxable services under a general label of "management fee" will make the entire transaction subject to sales tax. Consequently, for companies with large amounts of management fee income, substantial sales tax exposure could exist if the services are not separately stated in the agreement and/or intercompany invoices.
- A company's organizational chart should be analyzed for entities that have disregarded entities, as such entities are not normally treated as separate taxpayers for sales/use tax purposes and may have their own tax filing/collection requirements.
- Information technology/SaaS/software use or licenses provided within a management or administrative services agreement and included in the scope of the overall monthly/annual fee may cause significant sales/use tax liabilities if not treated appropriately on a multistate basis.
- Each state has different laws that dictate whether services and/or property provided are subject to sales tax. Therefore, each state in which the related companies have business activity should be considered in determining whether intercompany service fees are subject to sales/use tax.
- If intercompany transactions are significant, frequent, and occur on a multistate basis, sales/use tax software could be helpful in automating taxability decisions and determining applicable state and local tax rates. In the United States alone, there are over 10,000 taxing jurisdictions.
- An intercompany invoice for the transfer of information technology (or depending on the state, intercompany services performed) should be issued separately from administrative fees or operating margin determined via transfer-pricing policy.
- Sales or use tax should be self-assessed on all taxable intercompany transfers. The parent company may also charge and collect the sales tax from the related party in lieu of use tax being paid. State registrations should be completed, and sales/use tax returns should be filed and paid in the appropriate jurisdictions.
- A company should maintain proper documentation outlining what pertains to information technology versus other related service costs.
Following these steps should serve to mitigate issues that often arise and ensure that the sales and use tax is not paid on the cost in excess of the actual transfer of the information technology component or other taxable item. It also should prevent the issuance of penalties and interest if transactions are audited by a state tax authority.
Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or email@example.com.
Contributors are members of or associated with Grant Thornton LLP.