Amy hamilton fate of mtc tp 2015 05 04 by Ednaldo Silva

state tax notes™ Fate of MTC Transfer Pricing Program Hangs in the Balance by Amy Hamilton Amy Hamilton is a senior reporter with Tax Analysts. In this edition of A Sharper Focus, Amy Hamilton writes that it appears unlikely that 10 states are ready to commit to a four-year charter period for a Multistate Tax Commission transfer pricing program but that economist Ednaldo Silva’s influence on state revenue departments is already one legacy of the effort.

The Multistate Tax Commission’s Executive Committee is scheduled to take up on May 7 the proposed design for its Arm’s-Length Advisory Service (ALAS) — but at press time, it was nowhere near having the target number of 10 states financially commit to the plan’s four-year charter period.1 According to MTC Deputy Executive Director Greg Matson, only six states — Alabama, Iowa, Kentucky, New Jersey, North Carolina, and Pennsylvania — have indicated they are interested in being charter members. Bleaker still, the District of Columbia, Georgia, and Hawaii — fully one-third of the jurisdictions that participated in the ALAS advisory group — have declined the MTC’s invitation to join the service as charter members. And Florida, another state that participated in drafting the ALAS design, had not yet made a decision. While 10 isn’t definitive as the minimum number of participants for launching the proposed ALAS program, the plan’s projected $200,000 cost annually per state over the four-year charter period is based on that figure. Budget constraints are already the major reason states cite for declining to participate. The idea behind the plan is for participating states to collectively share the expenses of contracting with economic consulting firms to prepare the transfer pricing analyses that would support their arm’s-length adjustments and to assess the studies submitted by taxpayers. The plan designers conservatively estimate that an MTC transfer pricing program would yield $110 million for participating states over the charter period. It’s possible additional states will commit by May 7. At press time the MTC still hadn’t heard from about 20 states

1 MTC, ‘‘Design for an MTC Arm’s-Length Adjustment Service,’’ May 7, 2015.

State Tax Notes, May 4, 2015

with corporate income taxes. It’s unknown what direction the Executive Committee will provide to the architects of any potential MTC project. Legacy The ALAS effort has not been an entirely academic exercise. During the first advisory group meetings, top revenue officials from nine states examined various IRC section 482 types of discretionary authority and other tools used by the states to make adjustments. They also shared the latest intercompany transaction issues spotted by their auditors and got a sense of the scope of the problem, particularly in separate-entity states. Florida, for example, recently collected $70 million in a single case in which a business underreported income for intercompany transactions. During the October 6, 2014, forum in which economic consulting firms met with the ALAS advisory group, revenue officials gained firsthand insight into how businesses structure intercompany transactions to avoid state taxes. For one thing, some businesses group separate-entity states as one entity ripe for exploitation, so separate-entity states should start viewing themselves from this perspective, too, revenue officials learned. Also, state tax officials have known for at least five years that taxpayers are replacing intellectual property holding companies as vehicles for income shifting with more sophisticated ‘‘embedded royalties’’ structures that hide or embed royalties within a service charge or in the cost of goods sold. But according to economic consultants, embedded royalty structures have been around about a decade longer than state revenue officials suspected. And according to consultants, because taxpayers generally use the comparable profit method to bury the royalty, extracting it is likely to require the use of another section 482 method approved under the Treasury regulations and by the courts. The MTC’s transfer pricing training for state auditors, which was held March 31 and April 1, is also attributable directly to the ALAS effort. Regardless of the fate of the ALAS project, the MTC plans to continue to offer transfer pricing training through its regular training program if there is sufficient state interest. Ednaldo Silva The MTC went big when it picked economist Ednaldo Silva to lead its first round of training on identifying relatedparty transaction issues for audit. Not only did Silva help

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‘‘Don’t be stuck; don’t do anything by rote,’’ Silva said. Silva said there are three paradigms for dealing with transfer pricing: transfer pricing based on comparables, transfer pricing based on formulary apportionment, and transfer pricing based on safe harbors. ‘‘The United States adopted the most complex and the most difficult paradigm to enforce,’’ he added. It’s not true that the rules the OECD and big accounting firms endorse are the solutions that U.S. states — or nations that are not members of the OECD, for that matter — have to adopt, Silva said. The notion that there is only one way to determine whether transfer pricing is at arm’s length is not practical, Silva said. ‘‘Today many people in transfer pricing are very sanctimonious about ‘arm’s length’ meaning, in a very narrow sense, ‘based on comparables,’’’ Silva said. ‘‘But we cannot be sanctimonious about it, because when I came to transfer pricing, no one used comparables. I introduced the notion of ‘Let’s use comparables based on companies.’’’ Silva said the very concept of arm’s length is an axiom from which a series of corollaries and implications is derived. ‘‘So we can define transfer pricing to include formulary apportionment, we can define transfer pricing to include safe harbors — it’s just a matter of revising the definition of it. You can’t be dogmatic about it,’’ he added. Drafting Team In discussing the CPM and the challenges in applying it, Silva provided tax officials with information on his background as part of the team that drafted the section 482 regulations. 376

Silva said he started as a consultant for the IRS working on a project with a portfolio of about 22 inbound cases in Manhattan involving taxpayers with foreign parents. Among the things the taxpayers had in common were persistent losses over multiple tax years and transfer pricing studies prepared by the major accounting firms using the resale price method to demonstrate that the companies had been operating at arm’s length. Silva said that as he investigated the cases, he began to realize that the problem was with below-the-line excess expenses, primarily with management fees and advertising costs. ‘‘So I introduced a method in which the assessment was based at the level of operating profit.’’ It’s a common concept in statistics, he said. Another statistics concept Silva introduced into the transfer pricing regulation drafting process was the notion that there are methods for measuring an acceptable arm’slength range of results rather than a point estimate. Silva said this happened when he was brought in to assist the IRS in an audit that had gone on for three years. The entire dispute between the IRS’s economist and the taxpayer’s economists was over the arm’s-length price. During a break in the proceedings, Silva asked whether the comparables of both sides fell within the same range of what could statistically be accepted as at arm’s length. ‘‘It’s a very simple question no one had asked,’’ Silva said. But once the concept was introduced and tested, the case was settled within months. Silva said both concepts he introduced into the section 482 regs are ‘‘very simple things in academic economic research.’’ Silva is now with RoyaltyStat, an economic consulting firm that conducts transfer pricing analyses using various databases — including a proprietary database of license agreements, which Silva said he developed while working on the section 482 regulations. Not only was the section on intangibles the most difficult to draft, but it was also the most controversial item among attorneys on the drafting team, Silva said. ‘‘I got this grand idea that I was going to leave the government and create this database and become wealthy,’’ Silva said. ‘‘Well, I did leave the government, and it took me several years to get the money to create the database, but I have not become wealthy. And the reason is that the federal government is not serious about transfer pricing. It does not enforce it.’’ CPM and Game Playing According to Silva, there are two major challenges in applying the CPM that lead to game playing. ‘‘One vulnerability is that we don’t really have comparables, even in the United States,’’ Silva said. The second major challenge, he said, is in the current preference for using the interquartile range to measure the arm’s-length range. Silva said that he would like both sides to stop spending a lot of resources trying to find comparables that don’t exist State Tax Notes, May 4, 2015

draft the section 482 transfer pricing regulations, but it was his responsibility to introduce what would become the CPM into the federal regulations. Silva also was the principal developer of the best-method rule and the concept of arm’s length as a reliable range of taxable income instead of a point estimate. Silva’s influence on state transfer pricing practices could be a stealth legacy of the ALAS effort, because in addition to leading the transfer pricing training, he also participated in the advisory group’s October forum. This means that through the ALAS effort alone, there was a six-month period during which Silva shared his theories with top revenue officials and auditors from the 12 states actively seeking to enhance transfer pricing enforcement. Some of what Silva’s been telling the states flies in the face of what companies involved in state transfer pricing litigation might like officials to hear. During his public presentation to the ALAS advisory group in October, for example, Silva said it’s preferable for states to adopt solutions amenable to the complexity of their cases. ‘‘Don’t be stuck; don’t do anything by rote,’’ Silva said.

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Treas. reg. section 1.482-9(b). Treas. reg. section 1.482-2(a)(2)(iii)(B). 4 Treas. reg. section 1.482-1(e)(2)(iii)(B) and OECD guidelines, section 3.57. 3

State Tax Notes, May 4, 2015

advocated including what are know in statistics as confidence intervals — but lawyers on the drafting team thought it would be too complex to have two different interval methods in the regulations. ‘‘I have subsequently made several arguments against the notion of interquartile range for adjustments, because it’s very wide, especially when the base of the adjustment is a large number,’’ Silva said. Economic Substance One aspect of Silva’s views that elicited cheers from taxpayers was his emphasis on the need for tax administrators to consider whether there are a business purpose and economic substance to the intercompany transactions, taking into account functions performed that add value, contractual terms, and risks assumed by multistate entities. One theory at the federal level and in the OECD is that if there are intangibles there will automatically be excess profits, Silva said. ‘‘I think that one is imprudent to make this kind of argument because it does not really have support in economic theory and doesn’t have support in empirical work,’’ he said. Just because a company has research and development doesn’t necessarily mean it has production intangibles, like patents and know-how, Silva said. And just because a company has advertising expenses doesn’t necessarily mean that it has marketing intangibles and that it’s earning excess profits. ‘‘But that is the thinking that one finds a lot in transfer pricing,’’ Silva said, adding, ‘‘I say there is something in between.’’ ‘‘You can have R&D produce patents and know-how and all kinds of manufacturing intangibles, but do these intangibles lead to barriers to entry? Do they lead to market concentration? If they don’t, it’s unlikely that you’re going to get excess profits,’’ Silva said, adding that ordinary profits are the more likely result. ✰

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and that he believes flexibility is the key to finding solutions. He recommended using safe harbors for less complex transactions. Silva said there are two ways to implement safe harbors. One way is to put limits on intercompany deductions, while another way is put a range or even a specific number on profitability. Silva said that not only do safe harbors reduce complexity and increase certainty for taxpayers and tax administrators, but their use also increases efficiency in the audit cycle. He noted that the OECD, which used to be hostile to safe harbors, is now receptive to them and that safe harbors have been introduced at the federal level covering low-margin services2 and loans and advances.3 Next, Silva said that while the interquartile range is used by several tax authorities, it is wider than other statistical intervals. As a result, the arm’s-length range defined by the interquartile range may be impractical. ‘‘Everyone, including the OECD, is stuck on this concept of interquartile range,’’ said Silva. But many statistical procedures have academic merit in which one can use ranges that are very narrow, he said. Silva added that while the section 482 regulations and the OECD transfer pricing guidelines state that the interquartile range provides an acceptable measure of the arm’s-length range, they also state that a different statistical interval may be used if it provides a more reliable measure of the arm’s-length range.4 As a member of the team that drafted the section 482 rules, Silva suggested that the regulations include not one but two interval concepts. In addition to recommending that the regulations include the interquartile range, Silva