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March 5, 2013
Can States Prevent Income Shifting?
by Amy Hamilton and Lee A. Sheppard

Full Text Published by Tax Analysts®

by Amy Hamilton and Lee A. Sheppard
A news analysis examines two controversial proposals to address asset transfers out of the state or out of the country: Montana would repeal its water's-edge election, and states would ignore arm's-length transfer pricing standards when using IRC section 482 authority under proposed Multistate Tax Commission model regs.

News Analysis

Opponents of the international consensus of separate company accounting and arm's-length transfer pricing frequently point to the successful use of formulary apportionment by U.S. states over a century. But unitary combination cannot pull in every item states may want to tax; it is subject to constitutional limitations.

Corporate taxpayers have become adept at transferring assets and associated income out of the reach of unitary combination -- to say nothing of separate-entity states. So, perversely, states may need a transfer pricing concept to get at these tactics. Or they may need to broaden the reach of unitary combination beyond the water's edge.

Two controversial proposals have surfaced in recent months providing a glimpse at the problem of asset transfers either out of the state or out of the country, and would take differing approaches to it.

Legislation introduced in Montana this year would repeal the state's water's-edge election and require worldwide combination. The state's Department of Revenue supports the proposal, and a legislative committee already has held a hearing on it. (Prior coverage.)

A water's-edge election is not required by the Constitution. Three decades ago, California and other unitary combination states acceded to intense pressure from the U.S. Treasury Department, congressional leaders, and the British government to provide a water's-edge election. This was despite the U.S. Supreme Court holding that worldwide combination is constitutional in its Container and Barclays Bank decisions.

But the times are changing, according to current and former Montana revenue officials. They believe the time is right to exercise the expansive tax jurisdiction endorsed by the Supreme Court.

In their testimony, Montana revenue officials said policymakers internationally are recognizing that arm's-length accounting results in a mess of a system that allows for manipulation on a transaction-by-transaction basis and for profit shifting. They said legislators around the world are increasingly having a hard time justifying raising taxes on their businesses and cutting services for their citizens while multinational corporations aren't paying their fair share.

A second proposal being floated in the states has the potential to become national in scale. The Multistate Tax Commission is considering taking up a project to draft model regulations establishing guidelines for states to use in making adjustments of income and expenses, either domestically or internationally, under IRC section 482 and state 482-type stand-alone statutes.

If initiated, the MTC project would explore whether states can design their own section 482 distortion and relief standards or whether they must use the OECD guidelines as espoused in the IRS's transfer pricing regulations. Put another way, such an MTC model potentially could say the states aren't going to follow federal regulations but base their own 482 distortion and relief standards on state formulary apportionment principles instead.

Properly understood, section 482 is a clear reflection of income concept. It says that the tax administrator may reprice a transfer between controlled entities if it does not clearly reflect income. The arm's-length method, and all its baggage, were later grafted onto the antiabuse concept. (Xilinx Inc. v. Commissioner, 567 F.3d 482 (9th Cir. 2009), reversed, 598 F.3d 1191 (9th Cir. 2010).)

Many states use federal corporate taxable income as the base for state corporate income taxes. So transfer pricing guidelines might be necessary to address income shifting enabled by the states' linkage to the federal tax code. Outbound asset transfers are playing havoc with the state corporate tax base, and taxpayers justify the results by pointing to federal rules.

For example, IRC section 351 nonrecognition transfers between related domestic companies have been used to move the income-producing assets to low-tax states. The states have been addressing 351 transfers piecemeal through addback statutes, assertions of nexus, sham transaction theory, and litigation over what is included in a combined report.

In recent meetings on the potential project, MTC Counsel Bruce Fort has noted that there is no easy state response to the problem of interstate transfers between affiliates. An MTC model regulation could provide states with a more global solution, he said.

Potential state remedies could include the forced combination of two or more subsidiaries, or the elimination of an in-state taxpayer's current and historic costs associated with a particular unitary asset held by a subsidiary. In either case, the asset or the transferee has to be part of the unitary business.

According to Fort, despite the apparent widespread availability of section 482-type discretionary authority in the states, only a handful use it with any regularity to respond to income shifting. He said the reason might be because of a belief that states would be bound to follow IRS regulations governing when and how section 482 authority may be used.

The MTC Income and Franchise Tax Uniformity Subcommittee next meets March 5, at which time it could vote on whether to take up such a project.

MTC Proposal

The federal government isn't concerned about 351 transfers because both donor and recipient are subject to federal tax and likely will be filing a federal consolidated return, Fort said. By contrast, transfers of intangible assets to foreign subsidiaries trigger gain recognition under IRC section 367, which may require recognition of periodic income.

"Transferring assets out of Delaware or Nevada is the equivalent," Fort said, but states don't have a corollary to section 367 deemed fixed periodic income. Such a statute would be unconstitutional. The commerce clause would prevent a state from imposing an exit charge on a transfer to another state. So Fort and the MTC have to work on repricing the transfer or forcing combination instead.

Fort said that at the federal level, section 482 is an accepted response to distortion created by section 351 transfers, and he cited federal regulations governing section 482 as well as IRS field service advice (FSA) published in 2001. Federal court consideration of section 482 to correct distortion caused by section 351 transfers has been mixed, Fort said, with most courts upholding the use of section 482. Some courts have suggested that Congress limited its reach to distortion in transfers of intangibles to IRC section 936 corporations.

While the effects of section 351 transactions are felt most strongly by separate-entity states, even combined filing states are susceptible to them, according to Fort. He said in separate-entity states, section 351 transfers continuing to cause problems include transfers of mortgage derivatives in the financial industry to non-nexus-holding companies, transfers to real estate investment trusts with out-of-state shareholders, and indirect or embedded royalty payments not covered by addback statutes.

Section 351 transfers continuing to give combined filing states problems include transfers to 80/20 companies not included on the unitary report and transfers to captive insurance companies not included on a combined report, Fort said.

The problem with these transfers is that the transferee is not part of the unitary business -- so its income is not apportionable under the Uniform Division of Income for Tax Purposes Act. Allied-Signal v. Director, Division of Taxation, 504 U.S. 768 (1992), held that due process requires a connection between the state and the person or property it seeks to tax.

Some policy questions MTC staff have presented for consideration by subcommittee members include:

  • Should such a model say the states are not going to use arm's-length accounting but instead go directly to a comparable profits or split profits method?
  • Should such a project be limited to section 351 transfers?
  • Should combined reporting be an allowable means of exercising state section 482 authority?
  • For combined reporting states, should such a model regulation include the authority to make subpart F income adjustments?
  • Is such a project necessary?

Fort said that should the subcommittee take up such a project, one of the first questions members will need to consider is whether states currently have section 482 authority.

At least 14 have their own stand-alone section 482-type statutes, according to Fort. The total is uncertain, however, in part because some state statutes do not mirror federal language, and in part because some revenue officials exploring the subject with MTC staff have been surprised to discover 482-type authority in their codes, Fort said.

Is section 482 authority inherent by virtue of state use of the federal code to determine state base income amounts? Fort said he would argue that it is. Meanwhile, most separate-entity states give their revenue commission ability to force combination when certain conditions are met, and Fort noted that some incorporate IRC section 482 as their standard.

"Section 482 presents an opportunity the states haven't really glommed on to," Fort said. "If they think they're subject to the arm's-length standards they're never going to use it."

States abandoned arm's-length pricing 50 years ago precisely because they believed it was unmanageable, Fort said, adding that transfer pricing reports aren't suited to the states and are expensive and cumbersome.

"While federal tax authorities have concluded that arm's-length pricing is the best means for implementing section 482 at the federal level, there are good reasons to assume that state legislatures did not intend to limit state taxing authorities to the arm's-length methodology," Fort said.

States with separate 482 statutes should have a strong argument that they can use state tax principles and ignore transfer pricing procedures and standards, Fort said, but having a state regulation might be a better tax policy. Absent a separate state regulation, Fort said, taxpayers would have a strong argument that the state is bound by use of the IRS's arm's-length accounting regulations by virtue of the state's incorporation of section 482 as part of the state tax base determination.


During his time as IRS associate chief counsel (corporate), Jasper L. Cummings Jr. of Alston & Bird LLP, Raleigh, N.C., wrote the FSA Fort cited, FSA 200125007.

According to Cummings, the FSA says that when a corporation with net operating losses acquires in a 351 carryover basis exchange a built-in gain asset that is immediately sold at a gain so that the gain can be offset by the NOLs, and the two corporations are commonly controlled, section 482 can be applied to reallocate the gain to the shareholder that had contributed the gain asset to the loss corporation.

"That does not overturn section 351; in fact it says 351 applies," Cummings told Tax Analysts. "It applies to transitory transfers by related entities of pregnant loss or gain assets. It does not involve the common state tax planning techniques of permanently placing businesses in other subsidiaries through 351 exchanges."

Cummings last year outlined some of the more "unusual and questionable features" of the proposed MTC project in a posting to Alston & Bird's tax blog at

"The proposal purports to be based on section 482 principles, but then it rejects the core section 482 principles as too difficult and time-consuming to apply," Cummings wrote. The proposed approach would reject the relevance of transfer pricing and focus "on the most contentious and ill-settled aspect of section 482 at the federal level: the extent to which a section 482 adjustment can override a statutorily authorized nonrecognition transaction," he said. Cummings added that this usually occurs only for transfers of intellectual property, which are now governed by other specific statutory rules.

Cummings said the authorities relied on by the MTC are not all supportive of the proposed approach, and described as wholly inapposite the citing of the 2009 North Carolina Court of Appeals holding in Wal-Mart Stores East, Inc. v. Hinton.

The facts of the case concerned Wal-Mart's well-publicized income shifting by means of leases. The group transferred ownership of its retail real estate to a wholly-owned Delaware REIT, to which affiliates operating stores had to pay rent. The rent payments were dividended back to the payer.

Wal-Mart's eastern regional store operator (the named taxpayer) halved its $3 billion North Carolina net income using a deduction for rent for 70 North Carolina stores. Most of this rent was dividended back to it and classified as non-apportionable nonbusiness income, not included on the return. The REIT also filed a North Carolina return, deducting the dividends. The state demanded that a combined return be filed.

The trial court granted the state's motion for summary judgment, also awarding penalties. Noting the circular flow of funds, the trial court stated that "there is no evidence that the rent transaction, taken as a whole, has any real economic substance . . . ." The state statute permitted the tax administrator to force combination, eliminating excessive intercompany payments, when the return filed did not disclose the true earnings from business carried on in the state (N.C. Gen. Stat. section 105-130.6 (1999)).

On appeal, the court held that the secretary of revenue was authorized to force combination of the taxpayer, the REIT, and an intermediate affiliate because separate filing did not accurately reflect their true earnings in North Carolina.

Relying on Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425 (1980), the court noted that functionally integrated affiliates could be combined. The court viewed Wal-Mart as effectively conceding that its business was unitary. The court dismissed the taxpayer's argument that the state could not force combination when intercompany transactions occurred at arm's-length prices.

According to Cummings, the "distortion" the court relied on "was not separating income from expense, but was based on the court's view that the taxpayer had reclassified what should have been rental income as dividends from a subsidiary, which dividends were not then taxed by North Carolina."

"That is a very narrow circumstance that depends on an apportionable versus nonapportionable income distinction and a dividends received deduction, none of which is mentioned in the MTC proposal," Cummings wrote.

Cummings said just as the proposal misconceives the narrow focus of the Wal-Mart decision, it misunderstands its own theory of separation of income from expense. Under the proposed MTC approach, a bank making loans and then transferring the loans to a subsidiary under section 351 would be viewed as improperly separating the loan income from the interest expense the bank pays to its depositors, Cummings said.

"However, this analysis entirely overlooks the fact that having a subsidiary holding loan does the bank no good unless it can get money out of the subsidiary," Cummings said. "Such money normally will come out as dividends. If the bank is taxed on the dividends, there is no separation of income from expense. If a state has chosen to exclude intercompany dividends, presumably the state knew what it was doing, or perhaps it should rethink that decision rather than write a regulation such as this."

Finally, Cummings said, the proposed approach is not always for full unitary combination when a suspicious asset transfer is discovered but for a combination of only the two corporations that were involved in the section 351 exchanges that the state finds problematic.

"Such a limited combination is both contrary to the Wal-Mart decision and unconstitutional," Cummings said. The MTC needs to develop a valid definition of what -- aside from non-arm's-length pricing -- is a distortion of true income other than "just any transaction that reduces a corporation's income reportable in one state," he added.

That is, Cummings argued that this approach might be unconstitutional under Allied-Signal and the commerce clause. Allied-Signal held that states may only require combination of the elements of a unitary business, and investment portfolio elements are not part of a unitary business. But under Wal-Mart, his banking example might be a unitary business.


Members of the American Institute of Certified Public Accountants provided comment on the proposed project during a series of teleconferences with an MTC liaison group. Jamie Yesnowitz, state and local tax principal with Grant Thornton LLP in Washington, is the chair of the AICPA's State and Local Tax (SALT) Technical Resource Panel.

Yesnowitz told Tax Analysts that the AICPA doesn't have an official position on the proposed MTC project but that members noted in their comments to the MTC "that there is significant state-to-state inconsistency when applying section 482 standards and authority, and that more certainty and some level of uniformity in this area would be helpful."

Yesnowitz said the AICPA members believe that if the MTC were to develop a regulation covering its thoughts on arm's-length pricing and other discretionary authority items, "before going too far in the process it would be best for the MTC to confirm how the states currently conform to the federal 482 standards, as well as the extent of the state statutes that provide discretionary authority to the state tax authorities."

"We thought that states would need to have legislative, statutory authority prior to adopting an MTC model regulation on the subject, and that combined reporting and other filing method changes should not be addressed in this project," Yesnowitz added.

He elaborated: "Focusing this particular project on arm's-length pricing, rather than covering the wide range of filing method changes, may increase the possibility that individual states working closely with the MTC will be supportive of the measure, increasing the overall chance that the project is endorsed by the MTC."

One of the MTC liaison group members is Alabama Assistant Revenue Commissioner Michael E. Mason, a former member of the AICPA SALT Technical Resource Panel. During one recent MTC subcommittee meeting, Mason mentioned that the groups had discussed exploring as a potential area of common ground state-style advance pricing agreements.

Yesnowitz said APA-style agreements could be something that interests the AICPA, but the practitioners would like to see what such a proposal would look like before commenting further. Finally, the AICPA also told the MTC liaison group that providing safe harbors and examples in any resulting regulation would be helpful to practitioners and taxpayers alike, Yesnowitz said.

Todd Lard, then vice president and general counsel for the Council On State Taxation, offered some informal observations during the MTC subcommittee's February 5 meeting. Lard said that while the MTC is presenting the proposed project as one meant primarily to provide guidance, to businesses it seems as though the intent is actually to develop rules allowing state nonconformity with federal concepts and guidelines in applying section 482 and possibly federal treatment of section 351 transactions.

Lard, now a partner at Sutherland Asbill & Brennan LLP in Washington, said departure from federal concepts would add tremendous complexity and uncertainty for corporate taxpayers rather than encourage more uniformity and simplification. He added that the memo cited from the Internal Revenue Code "is one of those 'clearly reflect income' standards, which we all know from reading the case law in different states is very difficult to determine and always ends up in litigation."

Further complicating matters would be considering how the proposed approach to section 482 discretionary authority would interact with UDITPA's distortion relief provision. Section 18 of UDITPA allows for alternative apportionment when the statutory apportionment method results in distortion and the proposed alternative is reasonable.

Lard said that while section 482 adjustments tend to be thought of as being between entities, UDITPA section 18 allows for adjustments between states, a concept foreign to the federal system. He warned of potential whipsawing if a state were adjusting intercompany transactions in a way that would affect the apportionment and divide it between two states.

Fort said he believes it would be incorrect to describe such adjustments as adjustments of income between states. "I think it's an adjustment of income between entities," Fort said. "If one of those entities happens to have been structured so that its only operations were in Nevada, then it would appear that you are making adjustments between states -- but really you're not; you're just making adjustments between entities."

Finally, Lard said, government only rarely gets to situations where it needs to apply 482 after exercising all other options.

"We always think of 482 as the very last card you'd ever play," Lard said. "What it sounds like is being proposed is a framework for states to use 482 much earlier, which would water down the evidentiary standard that government only use 482 at the very end of not being able to address a situation with whatever is codified.

"I think this suggests for a lot of taxpayers that this might not be a project that warrants going forward," Lard said.

Amy Hamilton and Lee A. Sheppard

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