United States

Utah: Tax Commission Required to Apply Federal Regulations in Transfer Pricing Dispute

Nov 14, 2016
From KPMG TaxWatch

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A Utah trial court recently addressed an issue of first impression in Utah—and likely in many states. The issue before the court was whether Utah’s discretionary authority statute, which is almost identical to IRC section 482, must be interpreted by applying the federal IRC § 482 regulations. The taxpayer at issue, a unitary business engaged in manufacturing and selling candy, sold its intellectual property (IP) to a related insurance company in exchange for stock in a tax-free transaction. After the sale, the insurance company licensed the IP back to the taxpayer at a rate that, per a transfer pricing study prepared by an accounting firm, would be paid by an unrelated party. The insurance company holding the IP was not unitary with the taxpayer and was therefore not included in the taxpayer’s unitary corporate income tax returns for the tax years at issue (1999 to 2007). The taxpayer deducted royalties paid to the insurance subsidiary for the tax years at issue, which reduced its Utah tax liability. The insurance subsidiary did not pay tax on the royalty income, as it paid tax in Utah only on premiums received. The taxpayer was audited by the Multistate Tax Commission for earlier tax years (1995 to 1998) and the royalty deduction was eventually accepted with a ten percent reduction.

The Utah Tax Commission (Commission) subsequently audited the taxpayer for the tax years at issue and invoked its discretionary authority statute to disallow the royalty deductions entirely.  This statute, codified at Utah Code Ann. § 59-7-113, provides that:

If two or more corporations (whether or not organized or doing business in this state, and whether or not affiliated) are owned or controlled directly or indirectly by the same interests, the commission is authorized to distribute, apportion, or allocate gross income or deductions between or among such corporations, if it determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such corporations.

In the Commission’s view, the deduction resulted in an understatement of the taxpayer’s income attributable to Utah because the insurance company did not pay tax in Utah on its royalty income. Further, the Commission determined that the structure of the IP transfer and subsequent licensing back would not have occurred with an unrelated party. The Commission did not evaluate whether the royalty was priced at arm’s length or whether there was a business purpose for the transaction. After the Commission denied the deduction, the taxpayer filed a petition for review.

The trial court first walked through the testimony of the various experts hired by the parties, and determined  that the primary issue before it was whether the Utah Legislature incorporated the federal regulations interpreting IRC § 482 when it adopted Utah Code Ann. § 59-7-113. If it did, then the federal rules, which supported the taxpayer’s royalty deduction, would likely determine the outcome.

The Tax Commission argued that Utah Code Ann. § 59-7-113 is a free-standing provision that gives it broad authority to adjust income without regard to (almost identical) IRC § 482 and the regulations promulgated thereunder. The only limit on its authority, the Commission believed, was an abuse of discretion statute.  The taxpayer, on the other hand, argued that federal regulations promulgated under a similar federal statute must apply for state purposes or there would be no limit to the Commission’s actions.

After a lengthy opinion that meandered through the various arguments made by the parties, the court concluded that “notwithstanding” the strength of the Commission’s case, the Commission’s discretion was intended to be limited by language outside Utah Code §59-7-113. As support for this position, the court determined the following:

  1. An earlier case addressing the Commission’s exercise of discretion under Utah Code Ann. §59-7-113 indicated that the Commission must rely on outside law to guide its exercise of this authority because the statute itself does not provide a formula for determining distortion or avoidance.
  2. The federal regulations must be applied because Utah has not adopted any specific state regulations to “fill in the blanks in the statute.”
  3. Utah’s income and franchise tax scheme relies heavily on federal definitions and Utah Code Ann. §59-7-113 is a “virtual copy” of IRC § 482, which, in the court’s view, indicated the Legislature wanted to apply federal guidance. The court also found a 1979 informal Attorney General opinion to be persuasive, as the Attorney General concluded that the Tax Commission may look to IRS rulings and regulations in applying the precursor to Utah Code Ann. §59-7-113.
  4. Per one of the taxpayer’s experts, the practice of applying the IRC § 482 regulations to address arm’s length transfer pricing is “not unusual” in other states.

Based on these conclusions, the court determined the Commission should have exercised its discretion applying the IRC § 482 regulations. Looking at all of the evidence presented, including the federal transfer pricing study, the court concluded that the transfer was at arm's length. Thus, the deduction was not barred under IRC § 482 and was therefore not barred under Utah Code Ann. § 59- 7-113. Next, noting that deductions are to be construed against the taxpayer, the court disallowed 10 percent of the royalty deduction, which was consistent with the earlier MTC audit. The Tax Commission has already appealed this decision. Please contact Chris Hoge at 810-237-15350 with questions on See’s Candies, Inc. v. Utah State Tax Commission.

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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.