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Utah Supremes affirm limited authority to modify transfer pricing

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On Oct. 5, 2018, the Utah Supreme Court affirmed a District Court decision upholding deductions for royalty payments made to a related party for the use of intellectual property.1 In doing so, the Court rejected an argument by the Utah Tax Commission (UTC) that Utah Code Ann. Sec. 59-7-113 gave it unfettered authority to reallocate income upon a finding of distortion of income for tax purposes. Instead, the Court found that the UTC’s discretion is limited by language outside the statute, specifically the regulations promulgated under Internal Revenue Code (IRC) Sec. 482.
 
Background See’s, a California corporation that sells candy in Utah through brick-and-mortar stores and catalog sales, is a wholly-owned subsidiary of Berkshire Hathaway, a publicly-owned conglomerate. BH Columbia is also a wholly-owned subsidiary of Berkshire Hathaway. Columbia Insurance Company (Columbia) is an admitted insurance company in Utah that is wholly owned by BH Columbia and sells insurance policies in Utah. As an insurance company, Columbia is not required to file Utah corporate franchise tax returns.2
 
In 1997, Columbia purchased intellectual property from See’s in exchange for stock in BH Columbia. The value of the shares of BH Columbia transferred was equal to the value of the intellectual property as determined by a transfer pricing study. The provisions of the transaction were set forth in a non-exclusive licensing agreement which provided that Columbia would protect and develop the intellectual property, and See’s would pay quarterly royalties to license it back. Accordingly, See’s paid quarterly royalties and deducted the payments from taxable income as business expenses. To ensure that the transaction met the arm’s-length standard for transfers between related parties promulgated under IRC Sec. 482, an outside accounting firm was hired to set the value of BH Columbia stock and See’s intellectual property. This valuation was also used to set the arm’s-length rate of royalties paid by See’s for the use of the intellectual property.

Utah is a member of the Multistate Tax Commission (MTC). As a means to provide guidance to its member states, the MTC performed a nonbinding audit of See’s and approved See’s Utah deduction for the 1995-1998 tax years subject to a 20% non-business royalty adjustment, which was later reduced to 10%.
 
In 2009, many years after the conclusion of the MTC audit, the UTC issued a Statutory Notice letter that disallowed See’s royalty deductions for the 1999-2007 tax years. Specifically, the UTC determined that Utah Code Ann. Sec. 59-7-1133 precluded the shifting of income between the two corporations because Columbia does not file Utah corporate franchise tax returns. The UTC’s auditors found that the shifting of income from See’s to Columbia resulted in an understatement of income attributable to the business operations of See’s. In an administrative proceeding following the audit, the UTC affirmed these conclusions but did not evaluate whether the royalty was priced at arm’s length or whether there was a business purpose for the transaction. See’s disagreed with the UTC’s decision and filed suit, resulting in the District Court controversy.

District Court decision On Oct. 6, 2016, the Fourth Judicial District Court in Utah County upheld 90% of the deductions for royalty payments made by See’s to Columbia for the use of intellectual property.4 The threshold question facing the District Court was whether Utah Code Ann. Sec. 59-7-113 is a stand-alone section giving the UTC authority to reallocate income if it concluded in its broad discretion that distortion of income for tax purposes or avoidance of income existed. See’s argued that, since the statute is virtually identical to IRC Sec. 482, related federal regulations should be used for interpretation and application. The District Court ultimately found that the UTC’s discretion was limited by those regulations. Further, since See’s met the federal arm’s-length transaction requirements outlined in the regulations, the District Court upheld 90% of the deductions. The UTC appealed the decision to the Utah Supreme Court.

Utah Supreme Court Analysis The Utah Supreme Court revisited the issue of whether Utah Code Ann. Sec. 59-7-113 reflects the federal arm’s-length transaction standard adopted by the IRC Sec. 482 regulations. While the UTC contended that the language and history of Utah Code Ann. Sec. 59-7-113 indicate that the Utah legislature made a deliberate decision that federal law should not be used to interpret the statute, See’s contended that because Utah Code Ann. Sec. 59-7-113 is ambiguous, the District Court properly considered its federal counterpart and accompanying regulations to define the scope of the UTC’s authority.

Legislative analysis

Agreeing with the District Court that the statutory phrase “necessary . . . clearly to reflect the income of any of such corporations”5 is ambiguous as to when the UTC has authority to allocate income, the Court first focused its analysis on the legislative intent and history of both Utah Code Ann. Sec. 59-7-113 and IRC Sec. 482.6 The UTC argued that the Utah legislature’s lack of an explicit reference to IRC Sec. 482 or the associated regulations meant that the Court could not look to those federal provisions for guidance as the Utah legislature did not intend for these provisions to be incorporated. See’s argued that the nearly identical language in the federal and Utah provisions meant that an interpretation of the Utah statute in light of IRC Sec. 482 and the associated regulations was required.

Congress enacted the relevant section of IRC Sec. 482, entitled “Allocation of Income and Deductions” to provide the IRS with a tool to address transfer pricing manipulation. While prior versions of the law required corporate entities to file a consolidated return, this version explicitly granted the IRS authority to allocate income between related entities. The Utah legislature adopted the language from this section verbatim in its initial enactment of Utah Code Ann. Sec. 59-7-113. Relying upon a previous ruling to ascertain the significance of a state legislature’s choice to borrow federal statutory language,7 the Court concluded that, absent evidence of a contrary legislative intent, “when our Legislature copies a federal statute, federal interpretations of the statute constitute persuasive authority as to the statute’s meaning.” Because of the shared statutory language, the Court found it appropriate to rely on the federal interpretation for guidance in resolving the ambiguity in Utah Code Ann. Sec. 59-7-113. The Court then extensively reviewed the federal guidance and the purpose behind its adoption.

Arm’s-length standard as applied by District Court

The District Court had acknowledged the unique nature of the See’s-Columbia relationship and considered expert testimony, as well as See’s transfer pricing study. Further, the District Court concluded that the transfer of assets was at arm’s length, justifying a deduction not barred under IRC Sec. 482 and, therefore, not barred under Utah Code Ann. Sec. 59-7-113. As the UTC did not challenge this factual finding, the Court affirmed the District Court’s determination.

Additional arguments

Both the UTC and the MTC (serving as amici to the UTC in this matter) made several additional arguments as to why the District Court’s decision was incorrect. In its decision, the Court addressed and rejected their contentions that:

  • The breadth of authority delineated in an earlier decision8 aligns better with a reading of Utah Ann. Code Sec. 59-7-113 that grants the UTC unlimited discretion to determine when allocation is necessary;
  • IRC Sec. 482 and Utah Code Ann. Sec. 59-7-113 differ in language and in context of application; and
  • Several other factors, including the distinctive aspects of the Utah tax system in contrast to the federal approach, illustrated that the Utah legislature did not intend for Utah Code Ann. Sec. 59-7-113 to be interpreted in harmony with IRC Sec. 482 and its regulations.9

In conclusion, the Court upheld the District Court finding that Utah Code Ann. Sec. 59-7-113 is ambiguous. Further, the District Court properly consulted interpretive guidance from IRC Sec. 482 and its regulations to resolve the ambiguity. Accordingly, the Court ruled that the District Court correctly employed the arm’s-length transaction standard to determine that the UTC improperly allocated See’s income.

Commentary The Utah Supreme Court’s affirmation of the District Court’s decision provides valuable insight into the scope and limits of the UTC’s power under Utah Code Ann. Sec. 59-7-113, an issue that had not previously been considered by a Utah court. In limiting the UTC’s authority to reallocate income, the Court has clarified that its power is limited by the standards provided in the IRC Sec. 482 regulations. Taxpayers should find some level of comfort in this limitation of power, many of which may had already assumed that states typically conform to IRC Sec. 482 and associated guidance unless there is clear contrary guidance.

Generally, it is rare for states to provide specific guidance departing from IRC Sec. 482 conformity. Instead, states allow their tax authorities a level of discretionary authority to reallocate income under the purview of statutes that generally look similar to IRC Sec. 482, as well as the power to change apportionment methodologies in cases where income is not properly reflected. One would expect that the close evaluation of transfer pricing controversies will continue, particularly in situations where industry-specific entities that have significant ties with related parties are excluded from combined returns, as was the case here. It will be interesting to see how state tax authorities will interpret their discretionary authority powers in light of this decision, and whether state legislatures will propose to expand the statutory provisions allowing state tax authorities to have broader discretionary authority so that their powers may be exercised independent from the federal transfer pricing standards.


 
1 Utah State Tax Commission v. See’s Candies, Inc., Utah Supreme Court, No. 20160910, Oct. 5, 2018.
2 As an admitted insurer, Columbia is instead subject to Utah’s premiums tax based on insurance premiums.
3 UTAH CODE ANN. § 59-7-113 provides: 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.
4 See’s Candies, Inc. v. Utah State Tax Commission, Fourth Judicial District Court, Utah County, No. 140401556, Oct. 6, 2016. See GT SALT Alert: Utah District Court Clarifies Scope of Discretionary Authority Provision as Applied to Transfer Pricing Issues. In its decision, the District Court, under the principle that deductions are narrowly construed against the taxpayer, adopted the recommendations made by the MTC in its audit that the deductions be adjusted downward by 10 percent, which reduced the deduction to the lowest level of the royalty rate range.
5 UTAH CODE ANN. § 59-7-113.
6 IRC Sec. 482 provides in relevant part: In the case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades or businesses, if he 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 organizations, trades, or businesses. Adopted by Revenue Act of 1928, Sec. 45.
7 Citing Utah Stream Access Coalition v. Orange Street Development, 416 P.3d 553 (Utah 2017).
8 Citing Continental Telephone Co. v. State Tax Commission, 539 P.2d 447 (Utah 1975).
9 Specifically, the MTC cited to the differences between See’s and Columbia’s state and federal income tax posture from a group perspective, the presence of formulary apportionment and combined filing, and other methods by which the UTC could remedy potential distortion in income as reasons for departing from the federal transfer pricing standards.




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