United States

Indiana: Forced Combination Was Appropriate, Despite Transfer Pricing Study

Mar 23, 2015
From KPMG TaxWatch

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In a recent Letter of Findings, the Indiana Department of Revenue addressed whether an auditor had established that the taxpayer’s separate return failed to fairly reflect the taxpayer’s Indiana income so that the Department could forcibly combine the taxpayer and certain affiliates. The taxpayer was a member of a federal consolidated group in the business of manufacturing, distributing, and selling consumer goods. The taxpayer owned a single-member disregarded entity that distributed the consolidated group’s consumer goods. The distributor made wholesale sales of the consolidated group’s products, which are produced by the group’s contract manufacturers. The auditor, after reviewing the group’s organizational structure and intercompany agreements, concluded that the Taxpayer, along with its Parent and distribution entity should file a combined return. It was not disputed that the entities were engaged in a unitary business. Specifically, the auditor determined that although the distribution operation had been organized to appear separate from the parent, it was in reality a captive operation. The corporate parent, the auditor concluded, controlled product marketing and pricing and retained product rights. The disregarded entity had limited risk, had no rights to the products for which it arranged distribution, and received only a small fee per unit rather than net income from sales of product. The auditor also noted that the costs of goods sold (COGS) reported by the taxpayer was inflated by a markup applied by the parent and the taxable income reported by the taxpayer was commission, rather than net income from a sales operation.

Upon review, the taxpayer argued that the auditor had not established that separate filing distorted the taxpayer’s income attributed to Indiana. The Department rejected these arguments, concluding that the audit had raised “legitimate concerns” that the taxpayer’s reporting of its Indiana income was distortive. Further, the Department rejected the Taxpayer’s claim that, under Rent-A-Center, the burden is on the Department to demonstrate that the separate company calculation was distortive. The Department distinguished Rent-A-Center because, in that case, the issue was whether the taxpayer was entitled to summary judgment as a matter of law. The Department found administrative protest is not governed by the Indiana Trial rules and the burden of proof does not shift once the Taxpayer sets out its argument challenging the assessment.  Thus, the Department placed the burden of proving that the proposed assessment was wrong with the taxpayer.

The Taxpayer also argued that the Department had not considered alternatives to combined reporting, which is required under Indiana law. Further, the taxpayer protested that the auditor did not “give necessary weight to its transfer pricing study.” The Department noted that parent increased its COGS by 80 percent when it sold the goods to the taxpayer, despite the fact that it never took possession of the goods and added no value to them. In addition, there were other manual adjustments to COGS that the auditor found to be distortive. The Department also addressed, and rejected, the taxpayer’s claims that the transfer pricing study justified its reporting positions.” Transfer pricing studies are not Indiana-approved vehicles for justifying tax expenses through controlled party profits.” The Department also noted that, although IRC section 482 studies do not apply to Indiana adjusted gross income tax, the study itself was lacking. It applied to tax years that predated those at issue and concluded that prices paid by the parent to its affiliates were arm’s length although they had not been revised in 30 years. The Department also observed that the auditor had considered alternatives to combined reporting and noted that those methods would have resulted in an assessment substantially greater than the assessment currently at issue. In conclusion, the assessment based on the entities filing a combined report was upheld, but the Department abated the underpayment penalty. Please contact Marc Caito at 317-951-2434 with questions on this Indiana Letter of Finding.

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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.