Friday, 18 May 2012

Transfer Pricing Approach Ruled Invalid in DC Court

A DC Administrative Law Judge ruled that a controversial application of the Comparable Profits Method (“CPM”), developed by Chainbridge Software LLC (“Chainbridge”) on behalf of state tax auditors, was invalid for establishing an arm’s length price (Microsoft Corporation, Inc. v. Office of the Tax and Revenue, D.C. Office of Administrative Hearings, Case No: 2010-OTR-00012; May 1, 2012). Attorneys for Microsoft successfully argued that Chainbridge should have compared each of Microsoft’s business activities involving intercompany transactions against companies performing similar functions, incurring similar risks and employing similar assets. Instead, Chainbridge benchmarked profits from the entire enterprise rather than to the controlled transactions.

Chainbridge operates as a subcontractor to contingent fee auditor ACS State and Local Solutions, Inc. State taxing authorities are reported to have generated more than $250 million in state income tax assessments since 2003, resulting in more than $100 million in collections in Alabama, DC, Louisiana and New Jersey, working with Chainbridge to apply this methodology in various taxpayer audits.

In the Microsoft case, Administrative Law Judge Paul Handy found that Chainbridge failed to conduct an appropriate comparable profits analysis of Microsoft’s 2002 income based on applicable law because they improperly aggregated all of Microsoft’s income, regardless of whether the income was derived from controlled or uncontrolled transactions. In his decision, Judge Handy noted that Chainbridge’s framing of the data renders the analysis useless in determining whether Microsoft’s controlled transactions were conducted in accordance with the arm’s length standard. (See for a copy of the decision, issued May 1, 2012.)

The use of third party contractors, such as Chainbridge, offers state taxing authorities a relatively low-risk, low cost means of recovering revenues that would otherwise go uncollected. Taxing practitioners have argued, however, that the primary purpose of state tax audits which utilize the Chainbridge approach is to generate assessments so onerous that taxpayers are pressured into settlements. In addition, as argued in the Microsoft case, assessments which rely on the Chainbridge approach do not comply with the transfer pricing regulations as established under Section 482.

The impact of this ruling remains to be seen as the DC Office of Tax and Revenue (“OTR”) and other revenue authorities, including those of Alabama, Louisiana, Kentucky and New Jersey, evaluate the continued use of the Chainbridge approach within their jurisdictions. The decision also raises questions beyond state and local tax as to the proper application of the CPM when analyzing the profits of multinationals with a number of intercompany transactions in several lines of business.

Source: Ceteris Transfer Pricing Times Volume IX, Issue 5‏