In today's economic environment, it is no secret that many states face significant budget shortfalls. In response to these circumstances, certain state treasury departments have begun to propose new income tax assessments based on transfer pricing studies that they have "outsourced" to third-party audit firms, often on contingent-fee terms. These arrangements, however, have left many taxpayers concerned. A state department of revenue's combination of broad powers to propose adjustments and enjoyment of significant deference from state trial courts has traditionally been tempered by an expectation that the department will carefully exercise its discretion in making its assessment. But taxpayers are left wondering whether this powerful check on what otherwise might be arbitrary or capricious assessments is effectively abandoned where that state turns to a third-party, operating without transparency and on a contingent-fee basis, to pursue assessments under a highly technical area of the law (i.e., transfer pricing) with which the state department of revenue may, itself, have only limited experience.
Not all taxpayers are remaining passive. Microsoft Corporation, for one, is challenging a DC tax assessment in the amount of $2.75 million plus interest, based on a contract auditor's transfer pricing report, by filing in the District of Columbia's tax appeals system. The closed hearing on summary judgment filed by Microsoft Corporation was held on April 11, 2012 in the district Office of Administrative Hearings ("OAH") (Microsoft Corp. v. District of Columbia Office of Tax and Revenue, DC Office of Administrative Hearings, No. 2010-OTR-0012, hearing on motion for summary judgment 4/11/12). Microsoft's protest of the DC tax assessment has been pending in the OAH since 2010.
In its motion for summary judgment and in the associated legal brief, Microsoft argued, that (1) the federal transfer pricing rules (which, for all intents and purposes, were adopted by the District of Columbia for the purpose of its assessment against Microsoft) forbid the inclusion of unrelated party transactions for the purpose of determining whether a taxpayer improperly priced a controlled transaction, (2) the rules similarly disallow the sort of aggregation used by the District of Columbia's experts, and (3) that the contract auditor's analysis failed to take into account various material deductions. (Microsoft also made additional arguments arising out of the District's practice of taxing partnerships, such as a Microsoft partnership subsidiary, on an entity level.) A ruling on the motion is likely within days, according to Alan C. Levine, the District's OTR Chief Counsel. Should the OAH deny Microsoft's motion, an evidentiary hearing is set for May 7 and 8.
The costs of settling cases with the tax authorities in the states are almost always lower compared with litigating and defending the cases in the court system. However, settling a case might only be a short term solution. Like the federal government, the states tend to come back with additional assessments for following years. And now the stakes and risks seem to have risen higher, as states have increasingly turned to transfer pricing theories (which themselves may be imperfectly understood by state Departments of Revenue) and contingency-fee outside consulting firms in order to make up revenue shortfalls.
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