A New York State administrative law judge ("ALJ") has issued a determination rejecting an attempt by the New York State Department of Taxation and Finance to forcibly combine an out-of-state manufacturing corporation with its in-state affiliated distribution company for New York State corporation franchise tax purposes, finding that the taxpayer successfully proved that its intercompany pricing was consistent with Internal Revenue Code § 482 principles. The ALJ held that the taxpayer successfully rebutted a presumption of distortion by showing that its intercompany pricing, which was consistent with a contemporaneous transfer pricing study and supported by the testimony and reports of its expert witness, was in accordance with § 482. In re Hallmark Marketing Corporation, DTA No. 819956 (N.Y.S. Div. of Tax App. Jan. 26, 2006).
Hallmark Cards, Inc. is engaged in the design, manufacture and sale of social expression products, all of which is conducted outside New York State, principally in Missouri and Kansas. Its subsidiary, Hallmark Marketing Corp., was its exclusive sales agent in the United States. Hallmark Marketing purchased the social expression products from Hallmark Cards and then sold them principally to third-party retailers throughout the United States, including New York State, in its role as a distributor. The purchase price was set based on a contemporaneous transfer pricing study ("§ 482 report") prepared by a CPA firm. The § 482 report employed the comparable profits method ("CPM"), one of the prescribed valuation methods under the § 482 Treasury regulations. An arm’s-length price was arrived at by analyzing the profits earned by comparable uncontrolled companies similar to Hallmark Marketing, and setting the price so that Marketing’s profitability would be consistent with that of the comparable companies.
Hallmark Marketing filed its own New York State corporate tax return and, having set its intercompany pricing consistent with the § 482 report, did not file a New York combined return with Hallmark Cards.
During the course of the State’s audit of Hallmark Marketing’s corporate tax return, the taxpayer gave the auditor a copy of the § 482 report to show there was no distortion in its having filed a separate return without Hallmark Cards. After taking no action on the § 482 report for 15 months, and with the statute of limitations about to expire, the State’s auditor determined that the report was "weak," and the State forcibly combined Hallmark Cards with Hallmark Marketing. (New York State does not have an advance pricing program that would allow a taxpayer to obtain advance approval of its intercompany pricing.)
Under the New York Tax Law and regulations, in order for a corporation to be required to file on a combined basis with another corporation, three elements must be present: (i) substantial ownership; (ii) a unitary relationship between the corporations; and (iii) distortion of the taxpayer’s New York income by filing on a separate company basis. Only the distortion element was in issue in Hallmark Marketing. The regulations create a presumption of distortion when the related entities engage in substantial intercorporate transactions. The New York State Tax Appeals Tribunal has consistently held that this presumption may be rebutted by proof that the intercompany transactions are at arm’s-length, such as by showing they are consistent with § 482 principles. See, e.g., Matter of Silver King Broadcasting of N.J., Inc., DTA No. 812589 (N.Y.S. Tax App. Trib., May 9, 1996); Matter of New York Times Co., DTA No. 809776 (N.Y.S. Tax App. Trib., Aug. 10, 1995); Matter of Sears, Roebuck & Co., DTA No. 801732 (N.Y.S. Tax App. Trib., Apr. 28, 1994); Matter of Medtronic, Inc., DTA No. 800306 (N.Y.S. Tax App. Trib., Sept. 23, 1993).
At the hearing, the State’s two expert witnesses — both of whom had testified for the State in other cases where forced combination was upheld — testified that the taxpayer’s § 482 report was flawed. The experts did not themselves perform a functional analysis or otherwise prepare a transfer pricing report to arrive at what they considered a fair price. Instead, they attempted to raise doubts on the reliability of the taxpayer’s proof. The ALJ held that the taxpayer rebutted the presumption of distortion because the § 482 report conclusively established that the intercompany transactions were conducted at arm’s-length prices.
One of the State’s expert witnesses claimed that Hallmark Marketing performed many activities beyond that of a traditional "distributor." In particular, he testified that Hallmark Marketing was responsible for creating "retail and brand equity" in the Hallmark name through, among other things, its distribution network and its skilled workforce. The ALJ found that the record did not support a conclusion that Marketing held nonroutine intangible organizational assets, noting that those assets were part of the creative function performed by Hallmark Cards, not Hallmark Marketing. The ALJ found material flaws in the witness’ failure to differentiate between theoretical economic theory and the legal reality that Hallmark Marketing itself did not perform some of the functions that the expert claimed it performed, and rejected the expert’s theory as speculative. He also pointed out that the State’s expert repeatedly misconstrued the crucial role played by Hallmark Cards in its role in designing greeting cards, advertising, and owning and controlling the Hallmark trademarks. According to the ALJ, the expert’s failure to distinguish between the activities of the respective legal entities resulted in incorrect conclusions on whether Hallmark Marketing actually created value that it allegedly was not being compensated for.
The State’s experts attacked each of the comparables selected for the § 482 report, claiming that Hallmark Marketing was more than a mere distributor, that the comparables were not of a comparable size, and that certain comparables operated in foreign markets. The ALJ rejected these attacks, noting the various steps taken by the CPA firm in carefully selecting the comparables. He pointed out that the study employed adequate screens for size and that the comparable companies that operated in foreign markets also operated in the U.S. market. Moreover, the additional functions allegedly performed by Hallmark Marketing were the type of value-added services one would expect from any high-volume distributor.
The ALJ pointed out that while the Tax Appeals Tribunal in In re Tropicana Product Sales, Inc. (N.Y.S. Tax App. Trib., June 12, 2000) acknowledged the importance of carefully chosen comparables, he found the facts in the instant case to be clearly distinguishable from those in Tropicana. First, he found that Hallmark used a sophisticated transfer pricing methodology that it continually updated. Moreover, the § 482 report used by Hallmark Marketing to set the transfer price was a far more exacting and thorough mechanism than the report in Tropicana. Finally, unlike in Tropicana, the § 482 report was contemporaneous and was given to the State during the audit, not shortly before the hearing.
Perhaps most important was the ALJ’s recognition that the central inquiry was whether the taxpayer’s intercompany pricing was "consistent with the reasonable and flexible approach suggested by IRC § 482, which recognizes the difficulty taxpayers face when trying to meet an arm’s-length standard." (Emphasis added.) In rejecting an approach that would otherwise impose an all but impossible burden for proving adherence to § 482 principles -- and a standard that would likely exceed the standards actually employed by the Internal Revenue Service -- the determination shows that reasonable adherence to § 482 principles should avoid forced combination.
This article appeared in State Tax Notes.
Paul Frankel and Irwin Slomka represented Hallmark Marketing in this case.