How can transfer pricing strategies help reduce sales tax liability?

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Transfer pricing strategies are most commonly associated with income tax planning, but they can also have significant implications for sales and use tax liability, especially for businesses engaged in intercompany transactions across state lines. Understanding how transfer pricing intercompany transactions are structured and documented is essential for managing both income and sales tax exposures.

1. Understanding Transfer Pricing and Its Relevance to Sales Tax

Transfer pricing refers to the pricing of goods, services, or intangibles transferred between related entities within a corporate group. The primary goal, as established under Internal Revenue Code (IRC) section 482 and its corresponding Treasury Regulations, is to ensure that these transactions are conducted at arm’s length that is, the prices charged between related parties should be consistent with those charged between unrelated parties under similar circumstances [1].

While transfer pricing is primarily enforced for income tax purposes, the prices set for intercompany transactions also form the basis for sales and use tax calculations. This is because sales tax is generally imposed on the gross receipts from the sale of tangible personal property or certain services, and the amount subject to tax is determined by the price charged in the transaction.

2. How Transfer Pricing Strategies Affect Sales Tax Liability

A. Setting the Taxable Base

When related entities engage in intercompany transfer pricing, the price set for the transfer of goods or services directly impacts the sales price reported for sales tax purposes. If the transfer price is set at a lower, arm’s-length value, the sales tax base is correspondingly lower, resulting in reduced sales tax liability. However, the price must be defensible as arm’s length to withstand scrutiny from tax authorities [1].

B. Avoiding Non-Arm’s-Length Adjustments

If a state tax authority determines that the price charged in an intercompany transaction is not at arm’s length, it may adjust the sales price upward for sales tax purposes, increasing the sales tax due. By employing robust transfer pricing strategies and maintaining proper documentation, companies can defend their pricing and avoid such adjustments [2].

C. Structuring Transactions to Minimize Taxable Events

Transfer pricing strategies can also be used to structure intercompany transactions in a way that minimizes the number of taxable events. For example, a company may centralize purchasing or distribution functions in a state with a lower sales tax rate or with favorable exemptions, thereby reducing the overall sales tax burden on intercompany transfers.

3. Key Considerations and Risks

A. Documentation and Compliance

States are increasingly scrutinizing transfer pricing intercompany transactions, not just for income tax but also for sales tax purposes. Many states have adopted IRC section 482 or similar provisions, granting their tax authorities the power to adjust intercompany prices to reflect arm’s-length standards. Proper documentation, such as transfer pricing studies and intercompany agreements, is critical to support the prices used and to defend against potential adjustments.

B. Consistency Between Income and Sales Tax Reporting

It is important that the prices used for income tax and sales tax purposes are consistent. Discrepancies between the two can trigger audits and adjustments. For example, if a company reports a low transfer price for sales tax purposes but a higher price for income tax, this inconsistency may be challenged by tax authorities.

C. State-Specific Rules and Enforcement Trends

States have become more sophisticated in their enforcement of transfer pricing rules, often engaging third-party consultants and developing their own expertise to challenge taxpayer positions. Some states, such as New Jersey, explicitly reference the use of IRC section 482 standards in their regulations and accept IRS Advance Pricing Agreements (APAs) as evidence of arm’s-length pricing, but reserve the right to challenge the underlying assumptions if they believe the state’s tax base is not fairly reflected [2].

4. Practical Steps for Reducing Sales Tax Liability Through Transfer Pricing

• Conduct a Transfer Pricing Study: Prepare a robust transfer pricing study that establishes arm’s-length pricing for intercompany transactions. This study should be updated regularly and reflect the economic realities of the transactions.
• Align Documentation: Ensure that the documentation used for income tax purposes is consistent with that used for sales tax reporting.
• Review State Sales Tax Laws: Understand the specific sales tax rules in each state where intercompany transactions occur, including exemptions, sourcing rules, and the treatment of services and intangibles.
• Monitor State Enforcement Trends: Stay informed about state-level transfer pricing enforcement, as states are increasingly challenging intercompany pricing and may use different methods or standards than the IRS.
• Consider APAs or Voluntary Disclosure Programs: In some states, entering into an APA or participating in a voluntary disclosure program can provide certainty and reduce the risk of future adjustments.

Conclusion

Transfer pricing strategies, when properly implemented and documented, can help reduce sales tax liability by ensuring that intercompany transfer pricing is set at defensible, arm’s-length values. This not only minimizes the sales tax base but also protects against state adjustments and penalties. However, companies must be vigilant in maintaining consistency, documentation, and compliance with both federal and state requirements, as state tax authorities are increasingly active and sophisticated in this area.

BT can help. Contact Ben Miller in our Transfer Pricing team to gain insights and advice.

Cited Sources

• [1]Internal Revenue Code Section 482 and Treasury Regulations: These provide the federal framework for arm’s-length pricing and are often referenced or incorporated by states in their own transfer pricing enforcement
• [2]New Jersey Division of Taxation, Technical Advisory Memorandum TAM-2012-1: This document explains how New Jersey applies IRC section 482 standards to transfer pricing and recognizes APAs as proper documentation, while reserving the right to challenge them if the state’s tax base is not fairly reflected.

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