State transfer pricing series: Be prepared for audits ramping up

Aug 31, 2020

There has been much discussion among practitioners and in the tax press on the issue of state transfer pricing. Numerous articles have been written and presentations at conferences given on the likely increase in audit activity.

Once primarily an international tax issue, transfer pricing has become increasingly important at the state level, with many states currently conducting intensive transfer pricing audits. Indeed, the number of such audits has quadrupled since 2015, and state revenue departments are adding transfer pricing resources – both auditors and outside consultants – even during the COVID-19 pandemic.   

This article, the first in a series on state transfer pricing, explores the historical perspective of state enforcement and state transfer pricing strategies. Other articles in the series will examine the topics in more detail. Businesses with significant intercompany transactions should be wary of the increased audits, both because of the potential negative consequences of intensive transfer pricing audits and because transfer pricing can present significant planning opportunities.

Historical perspective

Traditionally, transfer pricing in the state context focused on separate and combined state opportunities, utilizing federally developed transfer pricing concepts to align profit in combined-reporting states where appropriate. Correspondingly, state transfer pricing enforcement traditionally focused on large C corporations with operations in separate and combined states.

However, there is a misperception that transfer pricing audits occur only in separate return states. While separate return states have been the most active historically, many combined reporting states, such as California, have sophisticated transfer pricing regimes. Another example, one of the most notable state transfer pricing cases in recent history, Utah State Tax Comm'n v. See's Candies, Inc., arose in a combined reporting state.

The reality is that revenue departments in any state that taxes income can examine intercompany transactions between related parties and adjust the results of those transactions. As corporate structures have become more intricate, so has the scrutiny of revenue departments. The rise of pass-through entities as an alternative to the C corporation, for example, has led state revenue departments to examine intercompany transactions of limited liability companies, S corporations, and limited liability partnerships. In some states, pass-through entities comprise by far the largest share of transfer pricing audits. And, as states face decreased revenue from multiple external factors, including the COVID-19 pandemic, transfer pricing audits represent a potential revenue increase.

State enforcement

State transfer pricing audits usually focus on three related areas of interest. First, most states have adopted some form of the federal transfer pricing rules under section 482 of the Internal Revenue Code. Consistent with section 482, states examine whether the results of intercompany transactions are consistent with the 'arm's length standard.' Understanding the federal law, particularly the regulations promulgated under section 482 is critical to navigating the vast majority of state transfer pricing audits.

Second, states often examine whether the intercompany transactions have economic substance i.e., whether the transactions have a business purpose apart from tax avoidance. These inquiries are often related to the inquiries of traditional transfer pricing audits, though the regulatory enforcement extends beyond the ‘arm’s length’ concepts of section 482 and often into state specific regulations.

Finally, some states expressly disallow certain deductions for expenses between related parties. That is, the states require businesses to 'add-back' the deductions to their income. A state transfer pricing audit can focus on analyzing intercompany transactions with regards to these expenses and deductions.

State transfer pricing strategies

Transfer pricing laws are designed to prevent related businesses from manipulating their intercompany pricing to minimize tax burdens. Transfer pricing assessments usually involve adjusting the transfer pricing result to prevent income shifting. For companies with large dollar amounts of intercompany transactions, even a small adjustment in pricing can lead to significant tax increases for an audit period. The potential tax increases are only part of the problem for most businesses. Many state transfer pricing audits are time and resource intensive, lasting many years, and causing businesses to spend an inordinate amount of resources during the audit. The costs of complying with a transfer pricing audit can be onerous.

Fortunately, there are ways for businesses to minimize the risk of both transfer pricing adjustments and prolonged and expensive audits. First, companies should closely examine their operations and determine the amount and details of all current and anticipated intercompany transactions. Second, companies with or anticipating significant intercompany transactions should prepare or commission a transfer pricing study. This is critical as a transfer pricing study is among the best defenses under audit. At best, the transfer pricing study should be completed contemporaneously with the establishment of the intercompany transactions. At a minimum, the transfer pricing study should be completed contemporaneously with the completion of the tax return. Third, companies with a transfer pricing study should ensure that the results of the intercompany transactions remain consistent with the study. Companies should periodically review their studies and, when appropriate, update them to reflect recent business changes or market conditions.

Many transfer pricing inquiries close quickly if a company produces a contemporaneous, well-designed transfer pricing study. In the event a state revenue department proceeds with an audit, there are ways to minimize the risks and expense. Many companies limit risk and expense by negotiating with departments of revenue regarding the breadth and depth of a transfer pricing audit. In many instances, a cooperating company can limit the transfer pricing audit to specific years and specific intercompany transactions. Such arrangements can save both the company and the department time and resources. During audit, it is still possible to show that the intercompany transactions produce results consistent with the arm’s length standard or are otherwise appropriate.


With states experiencing financial pressures from multiple sources, including the COVID-19 pandemic, businesses can expect increasingly aggressive state audit activities. Many states believe that transfer pricing is an area in which substantial revenue can be collected. Audit activity has been increasing for years, and it will continue to as states rebound from the pandemic. Companies with significant amounts of intercompany transactions should consult their state tax and transfer pricing advisers for more information not only concerning how to manage current or potential transfer pricing audits but also how to utilize transfer pricing as an effective planning tool.