In November 2023, the State of Louisiana sued the oil and gas company ConocoPhillips for an alleged underpayment of $390 million in taxes in the period from 2008 through 2011. The suit could leave ConocoPhillips with a total bill of more than $700 million, including penalties and interest on the unpaid liability.
Louisiana argues that ConocoPhillips’ intercompany pricing for crude oil and natural gas was not supported by available market benchmark prices and was, therefore, not arm’s length (in other words, at prices that would have been realized between independent parties). The state is taking a hardline position that the company willfully distorted its profitability through improper transfer pricing. The state cites as evidence that ConocoPhillips’ U.S. financial results fell below those of the global consolidated group, and also below a benchmark performed by a consultant working for the state, thereby not meeting the arm’s length standard. In addition, the complaint filed claims that the information provided by ConocoPhillips throughout the state’s transfer pricing audit was inadequate, failing to benchmark prices for individual products reported.
ConocoPhillips is fighting the state’s allegations, claiming that the purported tax abuse did not occur, and any losses or low margins were the result of business conditions, not improper transfer pricing.
This aggressive transfer pricing suit may embolden other state Departments of Revenue (DORs) to prioritize transfer pricing audits and litigation as a means to protect their tax base. It also highlights the need for taxpayers to consider two-sided testing, i.e., considering the reasonableness of the transfer pricing from the position of all parties to the transaction, when evaluating transfer pricing and the importance of robust transfer pricing documentation to support positions taken.
United States Domestic Transfer Pricing
Domestic transfer pricing has been a growing area of interest for state DORs seeking ways to increase or protect their tax base. Most states have adopted some form of the transfer pricing rules under Section 482 of the Internal Revenue Code (IRC), either by reference or adopting statutes analogous to IRC §482.
State DORs, like the Louisiana DOR, may investigate transfer pricing similarly to how the IRS investigates transfer pricing. That is, they may conduct an audit, request similar transfer pricing and other supporting documentation, and may conduct their own benchmarking analyses to determine whether intragroup pricing meets the arm’s length standard. They may also hire economists (or outside firms) to help with this analysis. Like the IRS, if a state DOR concludes that intercompany prices are not arm’s length, they may make an adjustment, levy penalties, and/or disallow deductions for specific related-party payments, among other measures under their state’s tax statute.
Historically, states have not been aggressive with transfer pricing audits, focusing their DOR budgets on other areas. However, recent evidence shows that this is changing. More states are realizing the value of investing in their transfer pricing audit capabilities and taking a closer look at the complex multinational structures of their corporate constituents.
Louisiana and 16 other U.S. states are considered “separate reporting” states. Separate filing states tax individual entities within an organization, not the consolidated organization. This creates opportunities for groups to implement cross-state transfer pricing strategies. The recent state transfer pricing activity, including both audits and incentive programs, are concentrated in separate reporting states (with some exceptions).
Warning Signs
Over the past several years, many states have shown heightened interest in transfer pricing, and some (including Indiana, New Jersey, North Carolina, and, notably, Louisiana) developed temporary incentive programs to encourage taxpayers to self-correct any transfer pricing issues before an audit. Such incentive programs might entail the opportunity to enter into an advanced pricing agreement, voluntary transfer pricing disclosures or adjustments, or voluntary managed audits, often in exchange for penalty protection and waivers of interest. This kind of show of good faith by a state DOR, however, is typically a sign that its next step will be to audit constituents that do not voluntarily cooperate.
Steps to Consider When Preparing for a Domestic Transfer Pricing Audit
Preparing for a domestic transfer pricing audit is much the same as how to prepare for a federal transfer pricing audit, including the following steps:
- Perform a planning exercise to help ensure intercompany transactions are priced in an arm’s length manner as defined in IRC §482.
- Prepare contemporaneous transfer pricing documentation that meets the requirements of Treasury Regulation §1.6662 and aligns with IRS’ recent Transfer Pricing Documentation Best Practices Frequently Asked Questions (FAQs).
- Conduct periodic reviews of intercompany pricing to help ensure the results align with the stated policies and the current functional profile of the business. Timely adjustments should be made if results are not arm’s length.
If you have any questions or need assistance, please reach out to a professional at Forvis Mazars.