Wednesday, April 16, 2014

Revenue Finds Taxpayer's Transfer Pricing Study Insufficient to Establish Audit was Incorrect

Excerpts of Revenue's Determination follows:

Taxpayer sells its clothing products and fashion accessories in its own, branded stores. Taxpayer operates some of these branded stores within Indiana. In addition, Taxpayer has a licensing agreement with other retailers authorizing those retailers to sell Taxpayer's branded products domestically. These licensees have the right to distribute Taxpayer branded products domestically by various ancillary channels such as opticians and factory outlet stores.

These licensees pay Taxpayer royalties based on the net sale of the branded products.

A related entity, here called "Services Subsidiary," was established in 2001. "Services Subsidiary" operates a distribution and consumer service facility outside Indiana. "Services Subsidiary" also ships Taxpayer's products to Taxpayer's own branded stores, other department stores, and directly to consumers. According to the audit report:

[Services Subsidiary's] products are primarily shipped to [Taxpayer's] retail stores and wholesale customers via express delivery providers and common carriers, and direct to consumers via express delivery providers. [Taxpayer's] stores handle returns of [Service Divisions'] products and [Services Subsidiary] handles returns for [Taxpayer's] products. [Taxpayer] negotiates the manufacturing and procurement of [Taxpayer's] products which include eyewear, watches and fragrances.

Taxpayer objects to the above cited description stating that, "[T]he stores accept returns of branded product wherever it was purchased. There is no practical way to distinguish products brought from the stores or from third parties."

Taxpayer and Services Subsidiary share ownership rights to certain intellectual property. The audit report explained the purported relationship between Services Subsidiary, Taxpayer, and the intellectual property generated and exploited by both Taxpayer and Services Subsidiary.

[Taxpayer] and [Services Subsidiary] together own all of the material trademark rights used in connection with the production, marketing and distribution of all their respective products, both in the U.S. and in other countries in which the products are principally sold. [Taxpayer] and [Services Subsidiary] also own and maintain worldwide registrations and trademarks in all relevant classes of products in each of the countries in which [Taxpayer's] products are sold. [Services Subsidiary] owns all of the trademarks for North America and Canada. [Taxpayer] owns the trademarks used internationally. There is no separate royalty company . . . holding the patent and trademarks.

While Services Subsidiary reports the income from third-party licensing agreements for which it holds the intellectual property, the documentation presented by Taxpayer provides that Taxpayer employs the "licensing group professionals" that determine the strategy, logistic, and terms of the licensing policy for third-party licensing arrangements. Additionally, it is Taxpayer's vice-president of licensing that has final decision making responsibility for establishing rates paid by third-party licensees.

The Department's audit made an "adjustment" for the audited years to combine Taxpayer with Services Subsidiary to "fairly reflect income from Indiana sources" pursuant to IC § 6-3-2-2(l). In other words, the audit included Services Subsidiary in Taxpayer's Indiana income tax return on a combined basis.

The issue is whether the Department's audit was justified in requiring that Taxpayer and Services Subsidiary file a combined income tax return on the ground that Taxpayer's separate company return failed to fairly reflect Taxpayer's Indiana source income because of the intercompany transactions between Taxpayer and Services Subsidiary. The Department notes that the burden of proving a proposed assessment wrong rests with the person against whom the proposed assessment is made. See Indiana Dept. of State Revenue, v. Rent-A-Center East, Inc., 963 N.E.2d 463, 466 (Ind. 2012) (citing IC § 6-8.1-5-1(c)).

In order to prevail in its protest, Taxpayer is required to establish that the audit's determination – that Taxpayer and Services should file a combined return – was "wrong."

1. Transfer Pricing Study / Scope and Relevance.

Taxpayer's own reporting methodology reduces its Indiana income tax liability by approximately 50 percent. Taxpayer relies on a Transfer Pricing Study issued in 2001 to justify a 50 percent reduction in state tax liability. The Department raises legitimate concerns whether a twelve-year old study is sufficiently relevant or reliable to justify the claimed tax effect. Taxpayer itself recognizes this obvious discrepancy and states that its "business model has not experienced significant change since this time [and that] the economics associated with the various operations remain unchanged." Other than Taxpayer's bare assertion to that effect, Taxpayer has provided no specific information sufficient to establish that Taxpayer's retail, Internet, and wholesale business remains unaffected by the passage of twelve years or that the state of the national economy has left Taxpayer's business model and its economic relationship with Services Subsidiary unaffected.

However, even assuming that the Transfer Pricing Study was entirely relevant to an analysis of transactions which occurred during the audit period, the Transfer Pricing Study exhibits certain inconsistencies and deficiencies which are not adequately explained in or justified within the Transfer Pricing Study.

The Transfer Pricing Study was limited in scope from the Study's inception. The Study reviewed only "the distribution of finished goods by [Services Subsidiary]." The Study cautioned that "any other intercompany transactions are outside the scope of this analysis and, for purposes of this study are assumed to take place at arm's length." (Emphasis added). However, Taxpayer presents the study as sufficient to account for and reconcile Taxpayer and Service Division's numerous intercompany transactions. During the audit, Taxpayer rejected a suggested alternative method disallowing intercompany expenses "because it would involve extensive time in analyzing intercompany transactions." Given the limited scope of the Study's analysis, the Department is not satisfied that the Study thoroughly considered the parties' extensive intercompany transactions.

2. Brand Recognition / Administrative Functions.

The Department must also question whether the Transfer Pricing Study adequately considered the value of the brand recognition or the value of the front and back office functions that Taxpayer brings to its relationship with Services Subsidiary. As Taxpayer notes, "[Taxpayer] is one of the best-recognized brands in the United States . . . ." In addition to brand name recognition, Taxpayer brings its experience in design and product development, procurement, oversight of all product manufacturing, head office management, along with all "back-office" functions such as accounting and payroll. There is insufficient evidence that the Transfer Pricing Study recognizes the substantial contribution Taxpayer brings to its relationship with its distribution arm, the value of its strategic decision-making, or the inherent value Taxpayer adds to its premium-priced retail products. As noted in the audit report:

[Taxpayer] is involved in the transaction both before and after it is sold to [Services Subsidiary]. [Taxpayer] is involved in the design and materials to be incorporated into a product. It has complete control over how it is manufactured. [Taxpayer's] corporate officers have complete control over decision making at [Services Subsidiary]. Although [Services Subsidiary] handles daily decisions at its distribution center . . . . corporate decisions as to direction of the company are made by officers at [Taxpayer]. [Services Subsidiary] has no corporate officer salaries on its return. The only salaries they show are for the distribution center employees . . . .

Further, the Department also questions whether the Study recognizes the value Taxpayer contributed to its distribution arm when Taxpayer funded the third-party development of the "highly advanced and automated technology" central to Service Division's distribution facilities.

Whatever may be the actual value of Taxpayer's fashion accessories, both Taxpayer and the Department acknowledge that the brand name recognition and trademarks substantially enhance the actual retail value of those goods. However the Department must question whether the Transfer Pricing Study adequately considers the value of the intellectual property developed by Taxpayer and thereafter transferred to and shared by Services Subsidiary. As noted in the audit report:

[Taxpayer] is paying for marks it already owned and still controls by virtue of its ownership of [Services Subsidiary].

Taxpayer acknowledges these issues but states that Taxpayer received adequate compensation for the value of the intellectual property because Services Subsidiary took upon itself the burden of protecting and managing the intellectual property. Whatever credence may be given to Taxpayer's assertion, there is nothing which substantiates the value of the compensation Taxpayer received as compared to the value of the intellectual property transferred to Services Subsidiary.

3. Transfer Pricing Study's "Comparables."

Taxpayer points out that Services Subsidiary "most closely resembles a retail distributor" when it functions as a "direct distribution channel" and that when it functions as an "indirect distribution channel," it "most closely resembles that of a wholesale distributor." However, the Department questions whether the Transfer Pricing Study's review of "comparable retail distributor[s]" and "comparable wholesalers," was entirely sufficient. In each case, the Study's search for "comparables" yielded exactly one "comparable" which the Study itself concluded "was so small." In recognition of that obvious shortcoming, the Study resorted to adding four "comparable" wholesalers and nine "comparable retailers." However, there is little to substantiate that these thirteen various "add-ons" are analogous to Taxpayer's own business model especially when – as here – Taxpayer's business is so closely related to the brand name value inherent in the products Taxpayer creates and Services Subsidiary distributes.

Moreover, Taxpayer's Transfer Pricing Study, after determining the relevant "comparables," performed its analysis on a prospective basis. "For [Services Subsidiary] to earn this return, it must bear risks similar to those of comparable wholesale firms." The Study discusses the three types of risks that Services Subsidiary must bear in order to be comparable to wholesale firms which – at the time the study was performed – were borne by Taxpayer. The Study appears to arrive at it conclusion based on an examination of what should be and instead of what then presently existed. Taxpayer has not provided information that establishes whether these risks were subsequently shifted to Services Subsidiary.

4. Conclusion.

Although the Transfer Pricing Study may have had a certain, limited value at the time it was first issued and which may have assisted the parties in better understanding the financial and organizational relationship between the affected parties, the Department concludes that the Transfer Pricing Study is insufficient to establish the audit acted outside its statutory authority in requiring Taxpayer and Services Subsidiary file combined income tax returns in order to "fairly reflect and report the income derived from sources within the state of Indiana . . . ."

Taxpayer and the Department may disagree as to what does and does not reflect "economic reality," but the Department is unconvinced that the Transfer Pricing Study authoritatively reflects that reality. The annualized "adjustments" – allocating four percent of its earnings to Taxpayer and three percent of its earnings to Services Subsidiary based upon the limited scope of the Transfer Pricing Study – appear arbitrary and not fully warranted by the value and services each party brings to their relationship.

Taxpayer asks that the Department abate a ten-percent penalty which was assessed because taxpayer purportedly underpaid estimated taxes. Taxpayer challenges the penalty "regardless as to whether they represent negligence penalties or underestimated penalties." Taxpayer further explains that it "filed its returns following the prescribed statutory requirements . . . ."
Based upon the particular facts and circumstances attendant upon this Taxpayer, the Department is agrees that Taxpayer has established reasonable cause sufficient to warrant abating the penalty.