A recent decision by the Massachusetts Appellate Tax Board related to inter-company pricing may put state tax auditors on notice not to overreach when assessing the value of services and products provided between companies and their out-of-state affiliates.

The federal government often looks at transactions related to services, products and intangibles provided between U.S. companies and their overseas affiliates to ensure that arm’s-length prices are charged, but there have been relatively few state court decisions on this issue. In their zeal for maximizing revenue, however, states are increasingly looking at inter-company pricing, so more of these cases may wind their way to state courts.

The case involved International Data Group, a company headquartered in Massachusetts that had affiliates in other states. IDG is best known for the “For Dummies” series of guidebooks it publishes on technology and other subjects. IDG charged its affiliates for centralized services such as accounting and marketing. But the Massachusetts Department of Revenue decided that the amount the company charged its affiliates was not enough.

The DOR placed a higher value on those services and then assessed a tax based on the higher value. For tax years 1992-1994, the DOR imputed an additional $22 million in service value and assessed IDG millions in additional tax and interest.

The Massachusetts ATB ruled that the prices IDG charged its out-of-state affiliates were at arms-length and proper. The ATB ordered the DOR to abate the assessment related to the inter-company pricing issue. The 133-page decision was handed down on April 17.

The case indicates that states cannot artificially impute increased or decreased value of inter-company transactions in order to increase a company’s tax liability. Given the dearth of state transfer-pricing cases, the case may be relied upon in other states and should deter states from acting overly aggressively, or from making transfer-pricing adjustments without any kind of transfer-pricing expertise or valid methodology.

Representing IDG was Sullivan & Worcester LLP, a Boston-based law firm with offices in New York and Washington, D.C. “The decision that took up the bulk of the trial was the transfer-pricing issue,” said Richard Jones, one of the lead attorneys on the case. “There are not many decisions in the state tax courts on the issue of transfer pricing between related companies, especially for services provided by companies under common ownership.”

He acknowledged that there is a vast amount of federal case law involving this issue, especially involving companies with overseas subsidiaries.

However, he believes that as states search harder for tax revenues to make up for lost revenue from businesses that have closed or otherwise suffered during the recession, they are going to pursue new lines of attack, going after tax revenue from transfer-pricing agreements between affiliated entities located in different states.

“A lot of the press right now seems to be focused on international transactions, corporations that may perhaps use shelters overseas,” said Jones (pictured). “There is currently a regime in place to make sure that transactions between related entities in different jurisdictions are treated at arm’s length.”

However, he acknowledged that not all states have adopted the regime in Section 482 of the Tax Code, or they have their own rules.

At the time the case was brought, IDG operated with numerous subsidiaries, with about 50 in the U.S. and 62 overseas. The company has recently restructured. “They operate in a highly entrepreneurial, independent way, but IDG provides services like accounting, marketing and minimal management to these affiliates,” said Jones.

When services are provided from one entity to an affiliated entity, many states such as Massachusetts require that they be considered as having compensated each other at fair value. Over a three-year audit period, IDG charged its affiliates in the neighborhood of $48 million. The Massachusetts DOR audited IDG and concluded that the $48 million figure was too low and that it should have charged its affiliates an additional $22.1 million. The DOR taxed the company on that additional income, even though it was not actually received.

“The department’s conclusion was that it should have been paid,” said Jones. “This conclusion was reached at the end of a six-year audit.”

However, the Appellate Tax Board disagreed, and the commissioner took the auditor to task in his opinion, saying that he had made some incorrect assumptions, according to Jones. The auditor made the assumption that IDG should have broken even if it were charging fair market value for its services and he made a series of complex adjustments by backing out passive income and making it into active income, according to Jones. The auditor assumed that IDG had a significant number of expenses for the year, and he assumed that nearly all of IDG’s expenses were incurred in the provision of expenses to its affiliates.

“The ATB found that the assumption that the auditor made, regardless of the breakeven method, whether that was appropriate or not, was done wrong,” said Jones. “He assumed that nearly all of IDG’s services were in providing administrative services. They were actually for other services such as searching out and creating new businesses, passive investment activity and importantly stewardship.”

Stewardship involves IDG officers who sit on the boards of affiliates, fly out to board meetings and advise the affiliates.

IDG was also able to establish that unrelated parties charged less, not more, to perform similar services. “At the end of the day, what was actually charged, which was $48 million, was deemed to be the correct fair value and so no adjustment was made, so the imputed $22 million was improper,” said Jones. “So the commissioner did not follow the standard method of determining arms’ length pricing under Section 482, or the Massachusetts statute. The department did not distinguish between what activities conducted by IDG were feeable or non-feeable. There was a flaw with the novel breakeven method.”

Jones believes that transfer-pricing cases will come up more often now that states are desperate for revenue, but he thinks the IDG case may prove to be a cautionary tale for other state departments of revenue.

“They have to bring in expertise if they are going to do this kind of assessment,” he said. “That’s what didn’t happen here. They hired an expert for trial who was in the difficult position of backing up the initial assessment of whether the transfer pricing was proper. So the result may be that states when they do pursue it, if they do pursue it, arm themselves with experienced transfer-pricing experts.”

However, he acknowledged that starting this year, Massachusetts has begun using a unitary method of taxation in which transfer pricing doesn’t matter as much. “All the entities combine as one big company,” said Jones. “A state that adopts unitary will treat them all as one entity. This issue doesn’t exist as much on a unitary level.”

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