State transfer pricing series: Audit past and future – be informed

Sep 11, 2020

Transfer pricing, the engagement in intercompany activities, continues to be a hot topic in the tax world. As globalization drives companies into new jurisdictions, transfer pricing has risen to the fore, both from a planning and enforcement perspective. To believe that transfer pricing is mainly an international topic, however, is misguided. The engagement in intercompany activities across states has drawn increased scrutiny in recent history, with the number of state transfer pricing audits quadrupling since 2015.  

This article, the second in a series on state transfer pricing, explores the history of state enforcement in an effort to inform taxpayers for the future and plan accordingly. Informed businesses with intercompany transactions across state jurisdictions can both more effectively plan for intensive transfer pricing audits and better identify transfer pricing opportunities.

State enforcement background

At the federal level, transfer pricing is governed by the regulations promulgated under section 482 of the Internal Revenue Code. The section 482 regulations are substantial, however, the concepts found therein all drive toward application of one concept: the ‘arm’s length standard’. Specifically, the arm’s length standard promulgated under section 482 requires that the results of intercompany transactions be consistent with the results of similar transactions conducted between unrelated (‘arm’s length’) enterprises.

States are not bound by these federal regulations. Nonetheless, most states have adopted some semblance of the federal regulations, particularly the adherence to the arm’s length standard of section 482. Hence, understanding and applying federal section 482 regulation concepts to intercompany transactions across states can provide a strong base of protection under state scrutiny.

Still, states are not bound solely to the arm’s length standard and are free to push transfer pricing audits on other grounds. Intercompany transactions are often scrutinized at the state level in accordance with concepts like economic substance, business purpose, and, in the case of certain expenses and deductions, characterization.  While these concepts are not necessarily inconsistent with the arm’s length standard, they can certainly extend beyond it, leaving state transfer pricing open to considerable judgement and state transfer pricing auditors open to pursuing multiple avenues.

State enforcement history

States have pursued transfer pricing audits for decades, but seriously began investing resources into the field in the mid-1990s. Originally, state transfer pricing audits were often focused in states where ‘separate’ reporting was required. In contrast to the 28 current ‘combined’ reporting states, where a single state tax return for the parent company and its affiliates is filed, regardless of location, the 17 current ‘separate’ reporting states, where a separate state tax return is required for affiliates, allowed for the potential abuse of intercompany pricing. By setting the price of intercompany transactions to shift income to entities in combined reporting states through intercompany transactions, tax in separate return states could be avoided, and state auditors were keen to catch such malfeasance.

More recently, however, states of both designations, separate and combined, have developed transfer pricing audit strategies. Some states have invested in developing internal resources while others pursue external firms and advisors to staff audits and provide expertise. A cottage industry of sorts has arisen as states seek assistance in navigating transfer pricing audits, and there is opportunity for considerable growth and new ideas in many states if audits continue to increase.

Indeed, novel approaches have arisen in recent years. In 2015, for instance, the Multistate Tax Commission established an initiative to unite states interested in transfer pricing, encourage information sharing among them, and, ultimately, train groups for transfer pricing audits. The initiative, originally known as the Arm’s Length Adjustment Service and later dubbed the State Intercompany Transactions Advisory Service (SITAS) has been pursued by at least a dozen states, with many more expressing interest as the states collaborate and experts provide assistance.

Many of the SITAS participants, and a number of states outside of it, have invested in training, experts, and initiatives outside the program to assist under audit. Correspondingly, the number of associated disputes has increased, with some leading to amplified litigation. In the past decade, the District of Columbia Office of Tax Revenue (OTR) pursued numerous transfer pricing disputes with taxpayers, including Microsoft and Pfizer, most of which involved experts from outside the OTR and most of which settled before trial. In 2015, the Indiana state tax court heard cases between the Indiana Department of Revenue and Rent-A-Center and the Indiana Department of Revenue and Columbia Sportswear. In 2018, the Utah Supreme Court ruled on a case between the Utah state tax commission and See’s Candies.

State enforcement today

State transfer pricing interest continues to grow in both amount and sophistication. In 2020, North Carolina announced a voluntary corporate transfer pricing resolution initiative which allows corporations to disclose their state transfer pricing positions after the fact and reach agreement with the state on intercompany pricing without facing additional penalties. On the other end of the spectrum, Indiana introduced an advance pricing agreement program in 2020, which allows corporations to reach agreement with the state in advance of intercompany transactions occurring so that transfer pricing is certain. Whether it is before the intercompany transactions occur or after the fact, transfer pricing is drawing increased attention.

State enforcement future

Facing decreased revenue due to multiple economic factors, including the COVID-19 pandemic, states are incentivized to explore potential increased revenue sources. Transfer pricing audits and the potential adjustments they represent provide readily available sources for many states. As multi-state initiatives such as SITAS and single-state initiatives such as dispute resolution and advance pricing agreements increase, so will the number of transfer pricing audits.


Businesses can expect increasingly aggressive state audit activities. Companies with intercompany transactions across state tax jurisdictions should consult their state tax and transfer pricing advisors to ensure they are well informed. Doing so will better prepare them and their enterprises for audits and opportunity.

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