Tax Management. 1 Steven C. Wrappe, Erin Collins, and Cameron Teheri, It

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1 Tax Management Transfer Pricing Report Reproduced with permission from Tax Management Transfer Pricing Report, Vol. 23 No. 16, 12/11/2014. Copyright 2014 by The Bureau of National Affairs, Inc. ( ) It Ain t Over Till It s Over, Part II: State Tax Implications Of Implementing a Sustained Federal Transfer Pricing Adjustment This is the second in a series of four articles organized by Steven C. Wrappe, partner at KPMG LLP, covering the federal tax, state tax, customs and financial statement implications of a sustained federal transfer pricing adjustment. Each article will refer to the same six factual scenarios. This article includes additional scenarios to more fully illustrate the state tax consequences potentially associated with a federal transfer pricing adjustment. BY BRIAN CODY, SARAH MCGAHAN, IAN NOVOS, SHIRLEY SICILIAN AND TROY YOUNG, KPMG LLP A s the number of global transfer pricing controversies has escalated, there has been increased attention to the federal income tax consequences of a sustained transfer pricing adjustment under Internal Revenue Code Section 482. In contrast, relatively little attention has been paid to the state tax consequences of a federal transfer pricing adjustment. Almost all states that impose a corporate income tax rely on federal taxable income to begin the computation of state taxable income. A Section 482 adjustment to federal taxable income can cause a change to the state tax base, apportionment and nexus determination, and may require the taxpayer to file amended state returns. This article, which is by no means exhaustive, identifies some of the state substantive and procedural issues a taxpayer should consider after a Section 482 adjustment. The first article in this series focused on the federal procedural consequences of a Section 482 adjustment under six different scenarios (outlined in the prior article and described in the appendix to this piece). 1 This article focuses on the state tax consequences under those same scenarios, and like the prior article, assumes that the tax authorities accept each other s transfer pricing adjustments. State Reporting Requirements After Federal Adjustments Given that federal taxable income generally is the starting point in computing state taxable income, states usually require taxpayers to report their federal tax adjustments resulting from an Internal Revenue Service final determination. Although the definition of final determination varies among the states, an IRS-initiated transfer pricing audit resulting in a primary adjustment 1 Steven C. Wrappe, Erin Collins, and Cameron Teheri, It Ain t Over Till It s Over: Federal Tax Implications of Implementing a Sustained Transfer Pricing Adjustment, 23 Transfer Pricing Report 872, 10/30/14. Copyright 2014 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. ISSN

2 2 2 In general, a primary adjustment is one that affects federal taxable income. 3 Ariz. Rev. Stat (A). 4 Ariz. Rev. Stat (G). 5 Ariz. Rev. Stat (D), (E). 6 Ariz. Rev. Stat (C); Cal. Rev. & Tax. Code 18622(b); Mo. Rev. Stat ; N.D. Admin. Code (2)(a). 7 Wis. Stat Colo. Rev. Stat (6)(a). 9 N.Y. Tax Law 211(3). 10 Cal. Rev. & Tax. Code 18622(a). 11 Mo. Rev. Stat (4); N. D. Cent. Code (7)(b). Note also, in North Dakota, a taxpayer that fails to file the return within two years of the final determination may not receive the credit or refund resulting from the federal adjustment. See N.D. Cent. Code (7)(b). 12 N.M. Code R Barnett Banks Inc. v. Florida Dep t of Revenue, 738 So. 2d 502 (Fla. Ct. App. Dist. 1, 1999). accepted by a taxpayer likely would qualify as a final determination for state tax purposes. 2 For example, Arizona requires a taxpayer to report to the state if the amount of taxable income is changed or corrected by the IRS within 90 days of a final determination. 3 Under Arizona law, a final determination has been made when the appeal rights of both parties have expired or have been exhausted relative to the tax year. 4 Furthermore, assessments under a partial agreement, closing agreement covering specific matters,... or advance payment are considered part of the final determination. 5 In addition to reporting corrections or changes to federal taxable income, some states require a taxpayer to file an amended state return any time the taxpayer files an amended federal return. 6 In other states, an amended state return may be required only if state taxable income changes as a result of the adjustment, or the adjustment affects certain state tax attributes. 7 Under either approach, a taxpayer will need to work through the effects of the federal adjustment on state taxable income. The length of time in which states require taxpayers to report federal changes or file amended returns varies from state to state. Taxpayers should carefully review applicable state statutes to ensure timely reporting or filing once a triggering event has occurred. For instance, timely filing in Colorado is within 30 days, 8 New York is within 90 days, 9 and in California federal changes must be reported within six months of the final determination. 10 The period for reporting federal adjustments to states generally falls in the range of 30 to 180 days. Failure to report a federal change in a timely manner can reduce interest due on a refund claim. In Missouri and North Dakota, if a report or amended return is not filed within the statutorily allotted time, interest on any resulting refund or credit ceases to accrue 90 days after the federal final determination. 11 In New Mexico, interest doesn t begin accruing until 120 days after the claim is filed. 12 In addition, the sooner a positive adjustment is reported, the less interest the taxpayer will owe. For state tax purposes, interest typically accrues from the original due date of the tax return until the tax is remitted with the amended return reporting the adjustment. There are some exceptions, such as in Florida where interest is due from the due date of the report notifying the state of the federal changes to income, 13 but taxpayers generally are best served by reporting adjustments in a timely fashion. Some states also assess penalties for failing to report federal changes within the required time frame. In 2014, Mississippi imposes a penalty of up to 1 percent per month (not to exceed 25 percent in the aggregate) in which a taxpayer fails to pay the additional tax due from an IRS adjustment, unless failure is due to reasonable cause and not to willful neglect. 14 This penalty is in addition to the underpayment of a tax interest rate of 1 percent per month. 15 In Pennsylvania, failure to report a federal change that increases taxable income can result in a penalty of $5 for every day the corporation is in default, unless the department abates the penalty. 16 Failure to timely report a federal change also can extend the period in which a state may review and assess additional tax. For example, a taxpayer s failure to file the necessary report with North Carolina s Department of Revenue extends the time in which a proposed assessment can be made until three years after receipt. 17 In Minnesota, if a taxpayer fails to report a change or file an amended return, the statute of limitation to assess based upon the federal change is extended to six years after the report should have been filed. In contrast, if the report or return had been timely filed, the period to assess is only one year. 18 Failing to timely report a Section 482 transfer pricing adjustment can have negative repercussions for affected taxpayers. State Tax Issues Associated With Federal Adjustments After ascertaining whether amended state returns must be filed, taxpayers must determine the state tax consequences flowing from the federal transfer pricing adjustment. A primary adjustment could result in changes to state taxable income as well as changes to state apportionment factors. Additionally, an increase in receipts or sales may cause some taxpayers to exceed state thresholds for when nexus is considered established. It also is important to consider the taxpayer s method of filing separate reporting, 19 water s-edge combined reporting, 20 or worldwide combined 14 Miss. Code Ann (4). 15 Miss. Code Ann (2). Mississippi recently enacted legislation that will reduce the underpayment interest rate beginning Jan. 1, Pa. Cons. Stat. 7406(a). 17 N.C. Gen. Stat (b)(1). 18 Minn. Stat. 289A.38, subd. 8 and Separate return states require each company with nexus in the state to file a separate return regardless of whether it is part of a federal consolidated group or is engaged in a unitary business with other taxpayers having nexus in the state. Separate return states include, but are not limited to Connecticut, Delaware, Florida, Georgia, Maryland, New Jersey and Virginia. 20 As the name implies, water s-edge combined reporting states typically exclude the income and apportionment factors of group members that are incorporated in foreign countries or that conduct most of their business outside the U.S. However, because some states include non-u.s. companies in the water s-edge group, it is important to review each state s statutes. For example, the California water s-edge unitary group includes DISCs, corporations whose average apportionment factors (property, payroll and sales) within the U.S. exceed a specific threshold, and export trade companies. See Cal. Rev. & Tax. Code Copyright 2014 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN

3 3 reporting 21 when analyzing the tax consequences of a federal adjustment. Tax Base In most states, the starting point in computing state taxable income is federal taxable income (generally determined with reference to line 28 or line 30 on Form 1120). If that starting point changes as a result of a federal adjustment, the state tax base likewise will change. To illustrate, in Scenario 1, the IRS made a primary adjustment decreasing U.S. Sub s cost of goods sold, thereby decreasing its expense deduction by $20 after determining the U.K. subsidiary overpriced its shoes. As a result, U.S. Sub s federal taxable income increased by $20. In a separate reporting state, U.S. Sub s increased federal taxable income would correspondingly increase its state tax base and therefore likely would increase the amount of tax it owed to the state (assuming that U.S. Sub s apportionment was unchanged and that it did not have offsetting losses to carry forward or tax credits to use). By the same token, U.K. Sub s income has decreased, and if U.K. Sub has nexus and filed in that state, it may be entitled to adjust its income downward. 22 In a water s-edge combined filing state, assuming that U.K. Sub even though within the unitary group is not included in U.S. Sub s water s-edge group, 23 the results for both the U.S. and U.K. subsidiaries should be the same as in a separate reporting state. The result could be different in the handful of states that allow unitary affiliates to file combined on a worldwide basis. 24 In a state where the U.S. and U.K. subsidiaries were able to file worldwide combined, the changes in income and expenses among these two combined group members should offset each other, resulting in no change to the combined, pre-apportioned tax base. In Scenario 2, U.S. Sub adjusted its income downward after the U.K. determined the shoes were underpriced by $20. For a separate reporting state, the decrease in U.S. Sub s federal taxable income would decrease state taxable income, thus potentially entitling 21 In states that require worldwide combined reporting or allow taxpayers to elect to file on a worldwide basis, the worldwide unitary group includes all unitary affiliates, regardless of their place of incorporation or level of U.S. business activity. 22 The U.S. Model Income Tax Treaty generally does not apply to state taxes. Therefore, a foreign entity may be subject to state corporate income tax even if the foreign entity is not subject to federal income tax due to treaty protections. But some states have nonetheless extended treaty protections to foreign taxpayers by statute or regulation. 23 It is possible that a change in transfer pricing would affect whether the foreign entity is excluded from the water sedge combined group. See, for example, MTC model combined reporting statute Section 5.A. vi., which does not exclude any member that earns more than 20 percent of its income, directly or indirectly, from intangible property or service related activities that are deductible against the business income of other members of the combined group, to the extent of that income and the apportionment factors related thereto. See Massachusetts (830 CMR 63.32B.2(2)(g)); West Virginia (W. Va. Code f(a)(6)). 24 See, for example, California (Cal. Rev. & Tax. Code 25101; Container Corporation of America v. Franchise Tax Board, 463 U.S. 159 (1983)); Massachusetts (830 Mass. Code Regs B.2); and West Virginia (W. Va. Code f). U.S. Sub to a refund. Alternatively, if U.S. Sub were in a loss position, its losses would increase. Likewise, if U.K. Sub had nexus and filed in the state, it might be required to amend its return to reflect an increase to its state taxable income. For a water s-edge combined state, the tax results again should mirror those of a separate reporting state a decrease in U.S. Sub s state tax base, and potentially an increase in U.K. Sub s tax base. And finally, in a state where a worldwide combined report was filed, no change in the combined tax base would occur because, as an intragroup transaction, U.K. Sub s increased expense and U.S. Sub s decreased income would offset each other. As demonstrated from the above examples, separate reporting and water s-edge combined filers will likely see a change in their tax base as a result of a federal primary adjustment that increases or decreases federal taxable income. Taxpayers filing on a worldwide combined basis with the foreign affiliate likely will not see a change in the state tax base as a result of a federal transfer pricing adjustment. Apportionment A federal transfer pricing adjustment also might cause a multistate taxpayer s apportionment to change in a given state. Formulary apportionment is a mechanism for dividing a multistate corporation s tax base among the states in which it does business. Apportionment assigns income to a state by way of a fraction representing the ratio of in-state factors to total factors, rather than tracing items of income (or loss) to the state where the income was generated. Formulary apportionment is a two-step process. First, the apportionable tax base is determined. This involves determining whether the taxpayer has the right to apportion, what income is apportionable and what income is not. After determining the apportionable tax base, the apportionment formula is then utilized to ascertain the percentage of the apportionable tax base attributable to each state. Traditionally, most states applied an equally weighted three-factor apportionment formula consisting of property, payroll, and sales. 25 However, a growing number of states now require use of a more heavily weighted sales factor formula 26 or even a single-sales factor formula. 27 A taxpayer s filing method separate, water s-edge combined, or worldwide combined can affect how its apportionment is computed and a change to the apportionment formula likely will change the amount of tax due in a particular state, or will affect the computation of NOLs. Under many state statutes or regulations, all gross receipts from transactions and activities in the regular course of the taxpayer s trade or business are included in the sales factor. 28 Thus, if a transfer pricing adjustment affects a taxpayer s sales or receipts, the taxpayer s apportionment percentage may change. 25 Uniform Division of Income for Tax Purposes Act 9 (NCCUSL 1967). 26 States generally employing a double-weighted sales factor apportionment formula include, but are not limited to: Arkansas, Florida, Massachusetts, North Carolina, and Virginia. 27 States generally employing a single-sales factor formula include, but not are limited to: California, Colorado, Georgia, Illinois, New York, New Jersey, and Wisconsin. 28 MTC Reg. IV.15.(a). TAX MANAGEMENT TRANSFER PRICING REPORT ISSN BNA TAX

4 4 In the six scenarios described in the appendix, the federal transfer pricing adjustment likely would likely not result in a change to U.S. Sub s apportionment regardless of whether U.S. Sub was filing a separate report, a water s-edge combined report or a worldwide combined report. The reason the apportionment formula, and in particular the sales factor, likely would not change in any of the six scenarios is that U.K. Sub, not U.S. Sub, is the entity making the sales. As such, U.K. Sub was the only entity with an increase or decrease in gross receipts in any of the scenarios. A change in an affiliate s gross receipts will not alter a taxpayer s apportionment percentages in a separate return state. Because foreign affiliates (for example, U.K. Sub) generally are not included in a water s-edge combined report, U.K. Sub s increase or decrease in gross receipts would not change U.S. Sub s apportionment under that method either. Under the six scenarios, in separate reporting and water s-edge reporting states, it is U.K. Sub that may be required to adjust apportionment, assuming it has nexus and filed in the state. U.K. Sub would need to increase its sales factor denominator and numerator to reflect the increased gross receipts from its sales to U.S. Sub, or conversely decrease its sales factor denominator and numerator in scenarios where the shoes were overpriced. On a worldwide combined report, despite U.K. Sub s increase of gross receipts in Scenarios 2, 4 and 6, apportionment likely would remain unchanged. This is because many states statutes eliminate gross receipts from transactions between group members. 29 Thus, of the original scenarios presented, it is unlikely any of them would result in a change to U.S. Sub s overall apportionment. And U.K. Sub s apportionment would change only in the separate and water sedge reporting states in which it had nexus and filed. To illustrate how a federal transfer pricing adjustment could affect a U.S. company s apportionment, assume under Scenario 4 that U.S. Sub is selling the shoes to U.K. Sub and the IRS has determined that the shoes are underpriced by $20. The IRS therefore increases U.S. Sub s gross receipts by $20. In a separate reporting state (assume the adjustment is attributable to U.S. Sub and not U.S. Parent), the sales factor denominator increases as a result of the $20 primary adjustment. The question then becomes how the additional $20 of gross receipts affects the sales factor numerator. In all states, receipts from sales of tangible personal property are attributed to the state where the goods are delivered. 30 Some states have adopted a so-called throwback rule whereby receipts from sales attributed to a state where the taxpayer is not subject to income tax are thrown back and included in the numerator of the state from which the goods are shipped. Because the shoes were destined for the U.K., the additional receipts resulting from the adjustment should not be sourced to any U.S. state under the state s rules. However, if the state has adopted a throwback rule that applies to sales made in foreign jurisdictions, 31 then the sale may indeed be included in U.S. Sub s numerator if it shipped the goods from that separate reporting state. If the state has not enacted a throwback rule, or if the rule does not apply in foreign jurisdictions, then U.S. Sub s denominator 29 See, for example, Cal. Rev. & Tax. Code 25128(d). 30 MTC Reg. IV.16.(a)(1)(a). 31 MTC Reg. IV.16.(a)(6). will increase, but with no change in the numerator. As a result, U.S. Sub s apportionment percentage will decrease and the tax base apportioned to the state should decrease. Note that because U.K. Sub is the buyer under this scenario, even if it has nexus and filed with the state, its apportionment to the state should not change. For a water s-edge combined state, the apportionment consequences should be the same as for a separate reporting state. In other words, unless the state has a throwback rule applicable to sales in foreign jurisdictions, receipts from sales of goods destined for the U.K. will not be included in the state sales factor numerator and the apportionment percentage should be decreased. In a worldwide-combined state, intercompany transactions typically are eliminated and therefore both U.S. Sub and U.K. Sub s apportionment likely would remain the same following the transfer pricing adjustment. Nexus Apportionment and nexus are somewhat intertwined in states, like California, that have adopted either economic presence or factor-presence nexus statutes. 32 Under California law, for tax years beginning on or after Jan. 1, 2011, a taxpayer is deemed to have nexus with California by virtue of having a certain amount of California-sourced receipts (that is, receipts included in the sales factor numerator). In general, the Franchise Tax Board will consider a corporation to have California corporate income/franchise tax nexus if it has more than $500,000 in California sales, $50,000 in California property, or $50,000 in California payroll. 33 If the adjustment causes an entity s sales in California to increase above the threshold, it could create nexus and a filing responsibility for that entity. For example, in Scenario 2, assume that prior to the transfer pricing adjustment, U.K. Sub had $499,999 of gross receipts sourced to California. In 2011, when California s factor-presence nexus statute became effective, U.K. Sub would not have been deemed to have nexus. However, after the $20 transfer pricing adjustment, if the increased gross receipts were attributed to California, then U.K. Sub would have exceeded the $500,000 nexus threshold and would be required to file a California return. Issues Unique to Separate Reporting States In a separate reporting state, each entity subject to the state s taxing jurisdiction is required to file a return 32 Application of Public Law is an additional issue taxpayers must consider. P.L prohibits states from imposing a net income tax on the income derived within a state from interstate commerce if the only business activity conducted within the state by or on behalf of the person during the year is the solicitation of orders by such person, or his representative, in such State for sales of tangible personal property, which orders are sent outside the State for approval or rejection, and, if approved, are filled by shipment or delivery from a point outside of the state. If the requirements of P.L are satisfied, regardless of the amount of sales made by a taxpayer in a state, a taxpayer is exempt from a state s net income tax. Not all states apply P.L to international sales; therefore, taxpayers must determine whether such international sales receive P.L protection on a state-by-state basis. 33 Cal. Rev. & Tax. Code 23101(b). The statutory amounts are adjusted annually for inflation Copyright 2014 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN

5 5 and pay tax on its income allocated and apportioned to the state. What makes a transfer pricing adjustment particularly difficult for state separate reporting is how the adjustment is attributed among the consolidated group members. When the IRS makes a federal adjustment, the adjustment generally is not allocated among affiliated members but is made to the consolidated group as a whole. For example, in Scenario 1, an IRS adjustment to increase U.S. Sub s income is directly associated with U.S. Sub (because no consolidated group exists), and therefore U.S. Sub s tax basis would increase in all states in which it files. But take, for example, Scenario 3 and 5, and assume a consolidated group does exist. The IRS adjustment on the purchase of shoes from the foreign affiliate could have been based upon a few arguments, including: that the marketing intangibles (that is, brand name) of U.S. Parent were insufficiently compensated, or that U.S. Sub was insufficiently compensated for its sales and distribution activities. Attributing an adjustment in this situation is straightforward because only two entities are economically relevant: an IRS adjustment for marketing intangibles would be attributed to U.S. Parent; an IRS adjustment for sales and distribution activities would be attributed to U.S. Sub. The tax base in each of the states these entities are filing in likely would increase. But, if several entities in the consolidated group are responsible for intangible property and multiple entities are responsible for sales and distribution, the situation gets much more complex. Conforming Adjustments: State Character Issues In addition to primary adjustments that affect federal taxable income, there are other transfer pricing adjustments conforming adjustments that will require some analysis for state tax purposes. Conforming adjustments are made after primary and correlative adjustments to reconcile the discrepancy created between the taxpayer s cash accounts and tax accounts in order to arrive at the appropriate federal income tax treatment of that shifting of income. In other words, the primary and correlative adjustments shift the income from one entity to another only insofar as tax liability is concerned. Deemed Dividends U.S. 71 (1992). Some conforming adjustments are treated for federal purposes as deemed dividends. If a transfer pricing adjustment is characterized as a deemed dividend from the foreign affiliate, one question that arises is whether the U.S. taxpayer will be allowed a dividends-received deduction at the state level. In Kraft General Foods, Inc. v. Iowa Department of Revenue & Finance, the U.S. Supreme Court addressed whether Iowa s separate entity income tax scheme, which allowed a dividends-received deduction for dividends received from domestic subsidiaries but not for dividends received from foreign subsidiaries, violated the Foreign Commerce Clause. 34 At the outset, the court observed the constitutional prohibition against state taxation of foreign commerce is broader than the protection afforded to interstate commerce. 35 Applying the heightened standard for challenges brought under the Foreign Commerce Clause, the court held that it was indisputable that the Iowa statute treated dividends received from foreign subsidiaries less favorably than dividends received from domestic subsidiaries because Iowa required inclusion of the former and not the latter in the calculation of taxable income. 36 Since Kraft, a number of state courts have struck down tax regimes where even inadvertently domestic dividends received more favorable treatment than foreign dividends. In the context of a water s-edge combined filing, the Kraft decision has been distinguished. Certain courts have held that in a combined reporting context, the Kraft decision does not apply because taxing dividends paid by foreign corporations is not discriminatory when the income of domestic subsidiaries also is subject to tax by virtue of being included in a combined report. 37 In evaluating the deemed dividend from a foreign affiliate, a taxpayer cannot rely upon federal treatment; rather a taxpayer must review state statutes and cases to determine the proper treatment of a conforming adjustment. For example, some states exclude dividend income completely. 38 It also is important to keep in mind that state variations from the federal dividendsreceived deduction can apply for domestic related parties as well. Deemed Contributions Other conforming adjustments are treated for federal purposes as deemed contributions. While there is minimal state authority addressing deemed contributions in the context of transfer pricing, states generally conform to Sections 118 and 351 of the Internal Revenue Code, which generally should allow for the taxfree treatment of contributions to capital. 39 Rev. Proc Rev. Proc , I.R.B. 296, allows taxpayers an alternative means to reflect a primary adjustment without the secondary tax consequences, such as withholding taxes, associated with the deemed dividend or capital contribution treatment. The revenue procedure sets forth the process for a taxpayer to characterize the conforming adjustment as an intercompany indebtedness transaction an interest-bearing account receivable or payable in an amount equal to the primary adjustment. Several states have adopted provisions that require taxpayers to add back certain expenses, including interest, paid to related parties that are deducted for federal tax purposes. In particular, separate reporting states use expense disallowance statutes to combat potential tax planning associated with separate apportionment Id. at Id. at Appeal of Morton Thiokol Inc., 864 P.2d 1175 (Kan. Sup. Ct. 1993); E.I. Du Pont de Nemours & Co. v. State Tax Assessor, 675 A.2d 82 (Me. Sup. Ct. 1996). 38 Ky. Rev. Stat. Ann (12)(b). 39 For example, California conforms to I.R.C. 351 and 118. See Cal. Rev. & Tax. Code 24325, Alabama, Arkansas, Connecticut, District of Columbia, Georgia, Illinois, Indiana, Kentucky, Maryland, Massachusetts, Michigan, Mississippi, New Jersey, New York, North Carolina, TAX MANAGEMENT TRANSFER PRICING REPORT ISSN BNA TAX

6 6 In states that require the corporations to file a combined report (assuming they are unitary), many of the benefits generated from such transactions effectively are eliminated when both the entity incurring the deduction and the entity earning the income are part of the same combined group. For example, if Rev. Proc was elected under Scenario 4 in a separate reporting state, the interest expense paid by U.S. Sub to U.K. Sub would have to be added back to U.S. Sub s tax base. In contrast, if U.S. Sub was the recipient of interest income, the interest income would increase U.S. Sub s tax base. The result could be the same in a water s-edge combined reporting state that requires addback for transactions with nongroup-member affiliates. In contrast, if worldwide reporting was used, then the income and expense would cancel each other out and eliminate the potential for tax planning on the part of the taxpayer. State Transfer Pricing Much of this article has focused on the state tax consequences associated with federal transfer pricing adjustments. However, increasingly, transfer pricing has become a more significant area of focus for state taxing authorities that can and do audit transfer pricing and are not necessarily bound by federal transfer pricing studies or federal advance pricing agreements. 41 A number of states, concerned about profit shifting, have been closely scrutinizing intercompany transactions on audit, or have hired third-party auditors to conduct transfer pricing specific audits, even among domestic domiciliaries. 42 Recently, the states efforts were buoyed when the Multistate Tax Commission an intergovernmental state tax agency began designing a program to provide various transfer pricing services to concerned Ohio, Oregon, Pennsylvania (beginning 2015), South Carolina, Tennessee, Vermont, Wisconsin. 41 In the past two decades several important state transfer pricing cases addressing related party expenses have been decided, including: Petition of Hallmark Marketing Corp., DTA No (N.Y. Div. of Tax App. 1/1/06); Petition of Tropicana Products Sales Inc., Dkt. No (N.Y. Tax App. Trib. 6/12/00); Petition of Silver King Broadcasting of N.J. Inc., Dkt. No (N.Y. Tax App. Trib. 5/9/96). Cases such as these contributed to New York amending its combined reporting statutes. 42 See Dolores Gregory, Citing Microsoft, D.C. OAH Reverses Assessments in Three Chainbridge Cases, 23 Transfer Pricing Report 968, 11/27/14. states. Officials from the charter states involved in creating the draft design of the program Alabama, the District of Columbia, Florida, Georgia, Hawaii, Iowa, Kentucky, New Jersey, and North Carolina recently received input from seven transfer pricing firms on the challenges and best practices for implementing a state transfer pricing program. A preliminary design draft of the program is expected to be presented to the MTC s Executive Committee in December 2014 and a final vote may occur as early as July Conclusion Overlooking the state tax consequences of a federal transfer pricing adjustment can be a costly mistake for state taxpayers. Taxpayers should be proactive rather than reactive when it comes to state transfer pricing issues and audits, and should not assume that federal transfer pricing studies or APAs will be sufficient for state purposes. This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP. 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 a company s tax adviser. Brian Cody, Sarah McGahan, Ian Novos, Shirley Sicilian and Troy Young are all members of KPMG s tax practice. Cody, based in Dallas, is a principal in the economic and valuation services (EVS) practice; McGahan, based in Los Angeles, is a senior manager in the state and local tax group of the Washington National Tax practice; Novos, also in Los Angeles, is a managing director in the EVS group; Sicilian, based in Washington, D.C., is a managing director in the state and local tax group of the Washington National Tax practice and serves as the national director of state and local tax controversy; and Young, also in Washington, is a senior associate in the state and local tax group of the Washington National Tax practice. The authors wish to thank Ann Holley of the Washington National Tax practice for her insight and suggestions in preparing this article. 43 See Dolores Gregory, MTC Panel Discusses Ways to Share Costs, Plans October Conference With Economists, 23 Transfer Pricing Report 517, 8/7/ Copyright 2014 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN

7 7 Appendix: Hypothetical Transfer Pricing Adjustment Scenarios UK Sub owns US Sub US Parent UK Sub Cash Shoes US Sub Type #1 Scenario Type #2 Scenario TP issue US (shoes determined to be overpriced by $20) TP issue UK (shoes determined to be underpriced by $20) Primary adjustment: IRS adjusts US Sub's income up Primary adjustment: HMRC adjusts UK Sub's income up Correlative adjustment: UK Sub Correlative adjustment: US Sub adjusts income down Conforming adjustment: Deemed dividend from US Sub to UK Sub Conforming adjustment: Deemed contribution from UK Sub to US Sub Revenue Procedure Relief: Treated as a loan from US Sub to UK Sub Revenue Procedure Relief: Treated as a loan from UK Sub to US Sub TAX MANAGEMENT TRANSFER PRICING REPORT ISSN BNA TAX

8 8 US Sub owns UK Sub US Parent US Sub Cash Shoes UK Sub Type #3 Scenario Type #4 Scenario TP issue US (shoes determined to be overpriced by $20) TP issue UK (shoes determined to be underpriced by $20) Primary adjustment: IRS adjusts US Sub's income up Primary adjustment: HMRC adjusts UK Sub's income up Correlative adjustment: UK Sub Correlative adjustment: US Sub Conforming adjustment: Deemed contribution from US Sub to UK Sub Revenue Procedure Relief: Treated as a loan from US Sub to UK Sub Conforming adjustment: Deemed dividend from UK Sub to US Sub Revenue Procedure Relief: Treated as a loan from UK Sub to US Sub Copyright 2014 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN

9 9 Ownership-US Sub and UK Sub owned directly by US Parent US Parent Shoes UK Sub Cash US Sub Type #5 Scenario TP issue US (shoes determined to be overpriced by $20) Primary adjustment: IRS adjusts US Sub's income up Correlative adjustment: UK Sub Conforming adjustment: Deemed dividend from US Sub to US Parent and deemed contribution from US Parent to UK Sub Revenue Procedure Relief: Treated as a loan from US Sub to UK Sub Type #6 Scenario TP issue UK (shoes determined to be underpriced by $20) Primary adjustment: HMRC adjusts UK Sub's income up Correlative adjustment: US Sub Conforming adjustment: Deemed dividend from UK Sub to US Parent and deemed contribution from US Parent to US Sub Revenue Procedure Relief: Treated as a loan from UK Sub to US Sub TAX MANAGEMENT TRANSFER PRICING REPORT ISSN BNA TAX