The Louisiana Department of Revenue (the “Department”) has joined the ranks of cash-strapped states looking to raise additional corporate tax revenue through scrutinizing transfer pricing and proposing adjustments. In transfer pricing audits, the Department looks at transactions between related parties (having common ownership) and seek to determine whether the transactions are priced as they would be if the parties were unrelated – i.e., whether the related-party transactions were made based on arm’s length standards. The current wave of arm’s-length transfer pricing audit activity in Louisiana is unusual, because Louisiana recently enacted an add-back statute and because the Department has been seemingly more active recently in attempting to assert the discretionary adjustment authority provided in La. R.S. 47: 287.480 to force related taxpayers to file combined returns.
During the past few years, the Department has worked with the Multistate Tax Commission’s (the “MTC”) transfer pricing initiative and Department personnel have received transfer pricing training from both the MTC and outside consultants. The Department is also sharing information with other states and the Service. The extent to which the Department is relying on outside consultants during the preparation of its quasi-transfer pricing study is not clear.
The Department’s recent arm’s-length transfer pricing adjustments rely on Louisiana’s transfer pricing statute (La. R.S. 47:287.480(2)), which tracks, verbatim, Internal Revenue Code Section 482 and permits the Secretary of Revenue to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among related businesses, if the Secretary determines that such distribution, apportionment, or allocation is necessary to prevent evasion of taxes or clearly to reflect the income of any of those businesses. Historically, the Internal Revenue Service (the “Service”) relied on Code Section 482 to make a wide variety of adjustments to the federal tax returns of related taxpayers. However, since the mid-1980s the Service has generally limited its application of Code Section 482 to arm’s-length transfer pricing adjustments for international transactions between related taxpayers. For its part, the Department appears to be targeting Louisiana taxpayers with intercompany royalty expenses for transfer pricing audits. But other intercompany transactions may trigger examinations as well.
The Department’s current arm’s-length transfer pricing audit approach relies on the comparable profits method, In essence, Louisiana auditors are coming up with their own “transfer pricing studies” for targeted taxpayers. The Department appears to be using the Compustat Global Database to identify comparable companies that engage in activities similar to the auditor’s understanding of the taxpayer’s activities and then attempts to locate those same companies in a proprietary third-party database that purports to compile royalty rates extracted from unredacted license agreements filed with the Securities and Exchange Commission. The Department also relies on largely undisclosed subjective and objective criteria to narrow the list of comparable entities, such as excluding any comparable entity with losses.
The Department’s arm’s-length transfer pricing adjustments contain two other significant flaws. First, if the Department’s own audit adjustment determines that a taxpayer’s operating profit margin is within the arm’s-length interquartile range, the Department still creates an adjustment to increase the taxpayer’s operating profit to the median operating profit margin. Second, the Department has attempted to apply its audit adjustments to one hundred percent (100%) of a taxpayer’s operating income, even if only a small portion of the taxpayer’s operating income relates to controlled transactions.
The current wave of Louisiana arm’s-length transfer pricing adjustments is cause for concern. Indeed, not only have the obvious flaws in the Department’s transfer pricing methodology already resulted in significant inappropriate adjustments, but there is reason to believe the Department will refuse to correct those errors, preferring to litigate one or more test cases that will set a favorable precedent for its methodology. Such a precedent could be damaging to any taxpayer that engages in related-party transactions and does business in Louisiana.
The Department’s recent approach to proposing arm’s-length transfer pricing audit adjustments reflect an attempt to apply a novel understanding of Code Section 482 transfer pricing concepts to Louisiana taxpayers. The Department’s proposed audit adjustments also suggest that the Department will not accept a taxpayer’s third-party transfer pricing study, even if the Service accepted that study and agreed that the taxpayer’s federal taxable income was correctly reported.
Properly documenting intercompany transactions is key to achieving a good result in a transfer pricing audit. Related taxpayers that engage in multi-state or international intercompany transactions should review their intercompany agreements and carefully document any intercompany transactions. That documentation should include a determination of the functions performed and assets employed by each party to the transaction as well as any risks assumed related to the transaction. Taxpayer’s should also regularly review and update their transfer pricing studies and internal transfer pricing methodology.
Because the Department is intent on pressing this issue, a taxpayer that has received an indication or a proposed assessment suggesting that the Department intends to raise a transfer pricing issue, should handle any response carefully. Once a proposed or formal assessment is issued taxpayers should take care to calendar all deadlines and strictly follow all procedural formalities for challenging/appealing disputed adjustments. It is important not to miss any opportunity to contest a proposed transfer pricing adjustment, because, until the Department refines its approach, many of the adjustments we have seen do not appear to correctly reflect income and are subject to challenge.
For additional information, please contact: Jaye A. Calhoun at (504) 293-5936; Jason Brown at (225) 389-3733; Willie Kolarik at (225) 382-3441; Phyllis Sims at (225) 389-3717; or Angela Adolph at (225) 382-3437