On October 1, 2016, the Indiana Office of Fiscal and Management Analysis of the Indiana Legislative Services Agency released a Combined-Reporting Study and a Transfer Pricing Study. These studies, which address corporate income tax issues, were required by legislation passed in 2016.
The Combined-Reporting Study discusses the reduction of state corporate income tax revenues in the recent past, both nationally and in Indiana. The transition of many business entities from traditional C corporations to pass-through entity status has had a negative impact on state revenues from corporate income tax, and Indiana’s corporate tax base has failed to keep up with the trend in U.S. corporate profits.
Currently, Indiana is a separate reporting state, meaning that each entity of a unitary group must file their income tax returns separately. Indiana, along with a handful of other separate reporting states, permits the election of consolidated reporting. A consolidated return is not a combined return, which means that all affiliated groups of a C corporation that have income or loss attributable to the state, file a single consolidated income tax return in the state. Combined reporting, in contrast, is when an income tax return is filed on behalf of an entire unitary group of an affiliated group of corporations.
The Combined-Reporting Study indicates that typically combined reporting “neutralizes several tax planning strategies like the use of intellectual property holding companies, transfer pricing, captive real estate investment trusts, captive insurance subsidiaries, and overseas management affiliates….” In turn, the Combined-Reporting Study also acknowledges that combined reporting can also create “complexities” in determining the unitary group, cause manipulation of sales-factor apportionment, and create additional administrative burdens.
A review of other state practices and hypothetical state combined-reporting produced mixed results. While the study emphasizes that most states have an estimated positive fiscal impact from the use of combined reporting, the studies also show that it is likely that the method will create reduced tax liability for some taxpayers. The data was equally inconclusive in determining whether the overall tax base of combined-reporting states was larger or smaller than separate-reporting states. Scholarly research on the matter produced similar results, but tended to be more favorable to finding increased revenue from combined-reporting.
The Transfer Pricing Study analyzed intercompany transfers. An intercompany transfer occurs when there is a company that operates in multiple states with multiple affiliates. When an affiliate makes a sale or transfer to another affiliate, absent tax implications, this transfer would generally be accomplished via an arm’s length transaction that would be comparable to the fair market value of the transaction. However, when there is a disparity in tax rates between the jurisdiction of one affiliate and the other, companies tend to “adjust” the transfer prices to affect an improved tax result. The Transfer Pricing Study presents a series of examples and illustrations exploring various transfer pricing practices. The Transfer Pricing Study also reviews state enforcement of these practices. While there is not a specific review of Indiana’s enforcement procedure, the Transfer Pricing Study warns that a poorly conducted transfer pricing study and thus a disallowed transfer pricing scheme could be costly to the taxpayer in terms of penalties and double taxation. However, the Transfer Pricing Study also observes that there are a variety of tax planning opportunities for multistate and multinational corporations via successful transfer pricing practices.