United States: Massachusetts Audits And Appeals Update—Transfer Pricing And Embedded Royalties

Last Updated: October 28 2014
Article by Michael A. Jacobs, Robert E. Weyman and Brent K. Beissel

Most Read Contributor in United States, October 2017

From time to time, we'll be using this space to discuss recurring Massachusetts state tax issues were seeing at audit and on appeal. In the first in this series, we'll focus on transfer pricing adjustments.

Over the past few years, the Department's auditors have aggressively attacked intercompany payments between affiliated entities—especially for tax years prior to mandatory combined reporting.

In our experience, auditors are typically applying these adjustments in two ways. First, the auditor asserts that the intercompany pricing is not at arm's length (referred to in the statute as "fair value"); and either increases an intercompany receipt item or decreases an intercompany expense item based on the auditor's own determination of an arm's length price under M.G.L. ch. 63, § 39A. Second, in situation where the auditor is applying a downward adjustment to an expense item, the auditor often recharacterizes the balance of the intercompany payment as an "embedded royalty" that is subject to the intangible expense addback. These corresponding adjustments can lead to large expense deduction denials at audit, and corresponding tax increases.

Recently, we've seen some particularly aggressive transfer pricing adjustments proposed, including adjustments in situations where:

  1. The intercompany pricing was based on third-party transfer pricing studies;
  2. There was no mark-up included in the intercompany charge;
  3. The transfer pricing adjustment included expenses for third-party charges and/or the intercompany price was mandated by federal regulation;
  4. The auditor denied a deduction for any portion of intercompany charge based on an incorrect application of the sham transaction doctrine; and
  5. One of the parties to the intercompany transaction was a utility corporation. (The Department's authority to make transfer pricing adjustments under M.G.L. ch. 63, § 39A does not extend to utility corporations).

The good news for taxpayers is that, in our experience, the Department is willing to settle transfer pricing issues, often on good terms, for taxpayer's with strong facts. We have negotiated these settlements throughout the appeal process—from the Department's mediation program through the Appellate Tax Board, and also assisted taxpayers that have successfully pushed back and reduced these adjustments at audit.

In addition, taxpayer's dealing with an auditor making a transfer pricing adjustment can take advantage of Massachusetts' long public history of proposed transfer pricing adjustments and turn some of the Department's own pricing methods to their own advantage. In past audits and appeals, we have seen the Department use Berry ratios, other industry-wide profit margin statistics, and adjustments based on the profit-margins of other entities in a consolidated group to come up with proposed pricing adjustments. Taxpayers facing a transfer pricing adjustment should review one or more of the methods that the Department has employed in other cases to see if any of those methods would produce a more favorable result

A taxpayer well-armed with supporting documentation justifying the intercompany pricing, as well as knowledge of the Department's own methodology, will be well-equipped to contest any transfer pricing adjustment; or perhaps avoid one altogether. For more information on the topic, contact the authors of this post or click the following link for slides from a presentation we gave in May transfer pricing in the state tax arena: Transfer Pricing Presentation.

This article is presented for informational purposes only and is not intended to constitute legal advice.

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