United States: District Of Columbia OAH Holds Transfer Pricing Study Is Arbitrary And Unreliable Basis For Determining Reallocation Of Income

The District of Columbia Office of Administrative Hearings (OAH) has issued an order reversing an assessment that was issued against a software company on the basis of a transfer pricing analysis.1 The OAH determined that the transfer pricing study was "arbitrary, capricious, and unreasonable" because it did not comport with appropriate transfer pricing methodology as allowed by the federal Treasury regulations interpreting Internal Revenue Code (IRC) Section 482.

Background

The District of Columbia Office of Tax and Revenue (OTR) issued a tax deficiency assessment for the tax year ending June 30, 2006 (the 2005 tax year) in the amount of approximately $2.75 million, against Microsoft Corporation. The assessment was based upon a transfer pricing analysis conducted by Chainbridge Software for the District.2 Chainbridge used a comparable profits method to analyze Microsoft's profit-to-cost ratio for the 2002 tax year compared to the profit-to-cost ratios of a similar entity (a "comparable" entity). However, Chainbridge did not limit its analysis to controlled transactions between Microsoft and its affiliated businesses, and instead, included all of Microsoft's controlled and uncontrolled transactions. As a result of the analysis, the OTR determined that Microsoft was shifting income to avoid paying tax in the District and Microsoft's use of a 2002 net operating loss carryforward for the 2005 tax year should be disallowed.

Microsoft filed a protest of the assessment with the OAH, an administrative-level board of review used to adjudicate tax and other disputes involving administrative agencies in the District. At a hearing before the OAH held in response to Microsoft's subsequent motion for summary judgment, the issue was whether Chainbridge's transfer pricing analysis, serving as the basis for the assessment against Microsoft, was "arbitrary, capricious, and/or unreasonable."

Microsoft's Arguments

Microsoft argued that Chainbridge improperly included all of its transactions, without separating out the controlled transactions, which produced unreliable results. The results, based on all transactions, made it appear as though Microsoft improperly shifted income to avoid the payment of taxes when this was not, in actuality, the case. According to Microsoft, most of the income included in the analysis related to transactions with third parties. Moreover, Chainbridge was required, under the federal regulations, to separate the transactions based on type (i.e. similar goods and services), but it failed to do so.3

OTR's Arguments

The OTR argued that the aggregation of all transactions in the transfer pricing analysis was proper because the transactions were so interrelated and the business structure was so complex and entangled.4 Also, the OTR claimed that Chainbridge considered the arm's-length transactions as well as the controlled transactions when it analyzed Microsoft's income. Furthermore, the OTR argued that Microsoft could have misstated its income with respect to uncontrolled transactions as well as controlled transactions. According to the OTR, this possibility made it even more appropriate to look to all transactions.

Transfer Pricing Study Was Arbitrary, Capricious and Unreasonable

The District authorizes the mayor "to distribute, apportion, or allocate gross income or deductions between or among" affiliated companies whenever such adjustments are necessary to prevent the evasion of taxes or necessary for the clear reflection of income.5 Because the language of the law is nearly identical to the language contained in the federal statute and the District has not promulgated corresponding regulations, the parties and the OAH agreed that the federal regulations serve as appropriate guidance.6

Under the federal regulations, the standard for transfer pricing analyses is whether the controlled transactions are conducted at arm's length. The controlled transactions must yield results that are consistent with the "results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances."7 In limited cases, the evaluator is also permitted to aggregate controlled and uncontrolled transactions. The regulations provide that aggregation is generally permitted only when the transactions are "so interrelated that consideration of multiple transactions is the most reliable means of determining the arm's length consideration for the controlled transactions" and the transactions "involve related products or services."8

A comparable profits method may be used to make the evaluation as to whether transactions are conducted at an arm's length.9 Under this method, the evaluator must select a "tested party" and determine the amount of operating profit it would have earned on related party transactions if its measures of profitability (at arm's length) were equal to an uncontrolled comparable's operating profit.

The OAH determined that Chainbridge's study, which aggregated the transactions and used the comparable profits method for its transfer pricing analysis, was unreliable for a number of reasons. Chainbridge aggregated all income, whether controlled or uncontrolled, on the tested party side of the analysis. The OAH found that the study's inclusion of all transactions was overly broad and that the OTR failed to provide any support demonstrating a need to aggregate. The mere fact that Microsoft had many affiliates was irrelevant since the inquiry related to the number of transactions, and not the number of affiliates.

The OAH pointed out that it appeared as though Chainbridge considered all transactions for the comparables as well as for Microsoft. Thus, Chainbridge's entire framework was flawed, resulting in a failure to identify the tested party's controlled transaction profit-to-cost ratio as well as a failure to identify the comparables' uncontrolled transaction profit-to-cost ratio.

In addition, Chainbridge's analysis failed to satisfy its required objective of comparing transactions that are "functionally comparable."10 Chainbridge made no effort to compare like-kind transactions, and instead, grouped all of Microsoft's transactions under the same umbrella of software. The failure to differentiate between Microsoft's various product and service lines resulted in a meaningless overall profit level indicator, as the profit levels in the different lines of business could vary substantially. While some level of discretion was permitted in its transfer pricing analysis, Chainbridge did not even attempt to address the purpose of the regulations. As a result, Microsoft met its burden of proof by showing that the transfer pricing study's unjustified aggregation of all transactions, controlled and uncontrolled, regardless of transaction type, was arbitrary, capricious and unreasonable.

Since Chainbridge's study served as the basis for the deficiency notice against Microsoft, the OAH ordered the reversal of the notice and granted summary judgment in favor of Microsoft.

Commentary

This decision represents a control on the level of discretion taxing authorities may exercise with respect to transfer pricing studies serving as support for an assessment, particularly when those studies are generated by third-party audit firms that are compensated on a contingent fee basis. In light of budget shortfalls, states have increasingly resorted to the retention of third-party audit firms to conduct (in the opinion of many) questionable transfer pricing studies that have worried multinational taxpayers with significant intercompany transactions. While some similarly situated taxpayers decided to settle outstanding assessments with the OTR based on third-party audit findings, Microsoft's willingness to elevate the issue to the OAH, and its success at that level, may have the effect of deterring taxing authorities from prospectively using third-party audit firms for transfer pricing studies.

Footnotes

1. Microsoft Corp. v. Office of Tax and Revenue, District of Columbia Office of Administrative Hearings, No. 2010-OTR-00012, May 1, 2012.

2. The OTR actually contracted with ACS State and Local Solutions, Inc. to provide the transfer pricing analysis, which subcontracted with Chainbridge to provide the transfer pricing analysis at issue.

3. Note that Microsoft also argued that Chainbridge made significant adjustment errors in its comparison of Microsoft's profit-to-cost ratio to those of comparable companies. Namely, it failed to deduct the costs of employee stock options that Microsoft offered to its employees, and also failed to consider the profits and costs of an affiliated partnership in 2002. The District taxes partnerships as entities and, as a result, allows for the deduction of partnership income by partners. Chainbridge only took into account the deduction, and did not consider the profits and costs of the partnership as well. As a consequence, Microsoft argued that it was not put on the same footing as the "comparables." The OTR admitted that Chainbridge should have deducted the employee stock options costs, but disagreed about the proper treatment of the partnership income. The OAH did not consider these arguments, however, because it found in favor of Microsoft with respect to its argument that the methodology used in the transfer pricing study was arbitrary, capricious and unreasonable.

4. Microsoft conducted thousands of transactions with over 100 affiliated businesses.

5. D.C. CODE ANN. § 47-1810.03.

.6 26 C.F.R. §§ 1.482-0 et seq.

7. The OAH cited to the federal regulations, 26 C.F.R. § 1.482-1(b)(1).

8. 26 C.F.R. § 1.482-1(f)(2)(i)(A).

9. 26 C.F.R. § 1.482-5(a).

10. The regulations require allocation of the costs, income and assets between the relevant business activities and other activities. See 26 C.F.R. §§ 1.482-1(d) and 1.482-5(c)(3)(iii).

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