In an era of increasing audit scrutiny, intercompany transactions are under the microscope like never before. Transfer pricing—once thought to be primarily an international tax concern—has become a major battleground in state taxation. As more states assert their authority to examine and adjust the pricing of related-party transactions, taxpayers must be prepared not only with economic support but also with airtight documentation and strategic foresight.

This article examines the key issues shaping state-level transfer pricing enforcement: the evolving legal standards, the role of documentation, audit strategies, and practical steps businesses can take to defend intercompany arrangements against state challenges.

The Expansion of State-Level Transfer Pricing Audits

The last decade has seen a major increase in state interest in transfer pricing. While states lack the extensive statutory frameworks and treaty obligations that govern federal or international transfer pricing, they have become increasingly aggressive in invoking their own statutes—often using language similar to Internal Revenue Code § 482—to recharacterize or disallow intercompany transactions.

Many states have adopted or expanded efforts originally spearheaded by the Multistate Tax Commission (MTC), including collaborative programs like the Arm’s-Length Adjustment Services (ALAS) and the State Intercompany Transactions Advisory Service (SITAS). These programs trained auditors, developed shared methodologies, and increased coordination across jurisdictions.

Even after the MTC dissolved SITAS, states such as Alabama, North Carolina, South Carolina, and Louisiana continued to invest in transfer pricing expertise, including the use of external economists and contingency-fee auditors.

What Are States Challenging?

States challenge intercompany transactions in a variety of ways. Common targets include:

• Royalty payments to affiliates (especially IP-holding companies)

• Management and service fees

• Intercompany financing or procurement arrangements

• Captive insurance structures

• Related-party leases or cost-sharing agreements

These challenges may involve:

• Reallocation of income under a state’s § 482-equivalent statute

• Application of economic substance or business purpose doctrines

• Imposition of addback rules for certain payments

• Use of alternative apportionment formulas or forced combination

Not Just a Separate Reporting State Issue

Contrary to common perception, transfer pricing enforcement is not limited to states that require separate company reporting. Even combined reporting states may challenge related-party transactions—especially during audits of pre-combined years or within water’s-edge groups, where foreign affiliates are excluded from the return.

In recent years, states like Connecticut, New Jersey, and Rhode Island have scrutinized intercompany transactions even after adopting combined reporting, particularly when global transfer pricing appears to depress U.S. income.

State Case Law: What the Courts Are Saying

Several high-profile cases illustrate how states and courts are approaching transfer pricing disputes:

• See’s Candies v. Utah State Tax Commission: Utah’s highest court held that while the state had discretionary authority to adjust intercompany pricing, it could not disregard a taxpayer’s royalty payments without analyzing the taxpayer’s IRC § 482-compliant transfer pricing study. The court found that the Utah statute’s similarities to § 482 required deference to federal guidance.

• Tractor Supply Co. v. South Carolina DOR: South Carolina imposed a combined unitary return based on perceived distortion caused by intercompany procurement fees. The court sided with the Department’s expert, rejecting the taxpayer’s markup as not arm’s length—but did not endorse broad application of forced combination. Instead, it emphasized the need for specific evidence of distortion and the lack of a better arm’s-length alternative from either side.

• IDC Research (Massachusetts), CarMax (South Carolina), Columbia Sportswear and Rent-A-Center (Indiana): These cases reflect judicial willingness to scrutinize transfer pricing arrangements where states demonstrate clear evidence of distortion or tax avoidance—but also show courts pushing back against arbitrary adjustments lacking economic justification.

“The Golden Rule” of Transfer Pricing Defense

A common refrain in transfer pricing audits is the idea that no court has set aside a contemporaneous, credible transfer pricing report prepared by a reputable firm when the state failed to produce its own competing report.

While recent cases may challenge the universality of this rule, it remains true that a well-prepared, prospective study—particularly one applying a recognized method like the comparable profits method (CPM)—offers strong defensive value.

But documentation must go beyond “checking the box.” It must be:

• Consistent with actual operations and intercompany agreements

• Contemporaneous, not post hoc rationalizations

• Based on real economic substance, not solely tax motives

Documentation Best Practices: Preparing to Withstand State Audit

The foundation of transfer pricing defense is documentation. Taxpayers should ensure that transfer pricing studies:

• Reflect the actual conduct of the parties (functions, risks, assets)

• Are updated regularly to reflect changing facts or laws

• Include intercompany agreements, payment flows, and supporting financials

• Avoid inconsistencies between legal structures and public statements or internal memos

Additional best practices include:

• Tracking all documents provided to the economist preparing the study

• Preparing GAAP-based separate company financials

• Maintaining cash flow evidence (e.g., payment confirmations)

• Avoiding the use of tax as the sole rationale for an arrangement

For multistate operations, it’s critical to document business purpose and economic substance in a way that aligns with state-level expectations—not just federal IRS rules.

Common Audit Disconnects and How to Manage Them

State auditors often lack experience with transfer pricing or apply federal concepts imprecisely. Common sources of tension include:

• Misunderstanding how intercompany pricing relates to functions and risks

• Viewing profit margins or losses in isolation without industry benchmarks

• Failure to apply correlative adjustments to counterparties

• Treating legal structures as inherently suspect without economic analysis

Taxpayers can reduce audit friction by:

• Requesting technical discussions directly with outside state consultants, where possible

• Asking auditors to identify the exact method they believe applies

• Seeking clarity on which transactions are being adjusted

• Raising constitutional concerns, such as double taxation or discriminatory treatment

Third-Party and Contingency Fee Auditors: Proceed with Caution

Many states now contract with outside economic consultants or litigation support firms for transfer pricing audits. These firms often work on contingency or under performance contracts. Their involvement raises concerns about:

• Incentives to overstate adjustments

• Lack of taxpayer engagement

• Privilege and confidentiality breaches

• Delegation of state authority to non-governmental actors

Taxpayers should monitor whether a third-party firm is influencing the audit, and consider asserting rights to:

• Limit access to confidential information

• Demand transparency in adjustments

• Challenge the use of unsupported data or secret comparables

Alternative Paths: Transfer Pricing Agreements and Settlements

To mitigate risk and resolve disputes efficiently, some states have developed voluntary Advance Pricing Agreement (APA) or transfer pricing resolution programs. Examples include:

• Indiana: Formal APA program

• North Carolina: Structured resolution process

• South Carolina and Louisiana: Informal or time-limited settlement initiatives

• New Jersey: Voluntary program supported by RoyaltyStat for reviewing studies

When participating, taxpayers should:

• Understand whether the agreement is binding, public, or non-precedential

• Insist on clear terms regarding applicable years, renewal, and modification

• Avoid overly broad waivers or admissions

• Confirm the state’s intent to apply consistent methods going forward

Closing Agreements and Final Considerations

Settlement agreements can be effective tools—but they carry their own risks. Common pitfalls include:

• Vague or overly broad release language

• Terms that conflict with federal filings or other states’ positions

• Inadequate coordination with intercompany counterparties

• Failure to resolve ongoing or prospective treatment

Before executing a closing agreement, taxpayers should evaluate:

• Whether the settlement includes finality for both entities

• Whether the agreement binds future audit positions

• The possibility of setting a harmful precedent

In many cases, the best strategy is to “work within the range”—accepting a mid-point adjustment while defending against more extreme positions.

Conclusion: Preparation, Consistency, and Defense-Ready Documentation

Transfer pricing at the state level is no longer a peripheral issue. With growing technical expertise, expanding audit focus, and increased pressure to raise revenue, states are becoming more sophisticated and aggressive in reviewing intercompany transactions.

Taxpayers must prepare accordingly—through prospective planning, robust documentation, and consistent internal and external communication. A solid transfer pricing study, aligned with economic reality and supported by thorough records, remains the best defense against state-level recharacterization.

When audits occur, strategic engagement—combined with legal and economic precision—can help taxpayers navigate disputes, avoid double taxation, and maintain defensible positions across jurisdictions.

© 2025 Jeanette Moffa. All Rights Reserved.