With both Halloween and the Multistate Tax Commission (MTC) Income Tax Audit selection nearing, taxpayers should prepare themselves for the possibility of being spooked in the near future. On Thursday, October 30, from 2-4 pm EST, the MTC Audit Committee—including representatives from the 22 states participating in the upcoming round of joint income tax audits—will be holding a teleconference that will begin with a public comment period. Because of the inevitable disclosure of confidential taxpayer information, the bulk of this meeting—including selecting the various companies to audit—will take place during the second half of the agenda and be closed to the general public. Just because a company has completed an audit in the past does not mean this season will be all treats. The authors have noticed that companies previously audited by the MTC can remain on the list of targets and are often repeat selections.

Unique Complexities

The MTC audit process is not without its share of traps for the unwary. First and foremost is the effort a taxpayer must expand in managing a multistate audit. Issues such as differing statute of limitations, the effects of federal Revenue Agent’s Reports (RAR) and net operating loss (NOL) differences on limitations periods, timing of protests, and tax confidentiality become of heightened importance when one auditor is reviewing a taxpayer for multiple states. Audited taxpayers should also keep in mind that the MTC does not issue the actual deficiency notices – these must come from the states. As a result there may be certain areas such as credits or refunds that the MTC does not review and must be raised directly with a participating state.

On the substantive side, a primary area of inquiry of an MTC audit has been and is likely to continue to be inter-company transactions. Historically MTC audits have taken a variety of approaches to disallow a taxpayer’s intercompany structure, including collapsing separate affiliates, applying the sham transaction doctrine, or using aggressive addback concepts. Another similar concern for taxpayers audited by the MTC is the increased likelihood of transfer pricing issues being raised. This comes in the wake of the creation of the MTC Arm’s-Length Adjustment Service (ALAS) this summer, led by former Montana Department of Revenue Director Dan Bucks. The group recently held a transfer pricing summit at which it designed the MTC services to include third-party economic consultants at every stage. The MTC transfer pricing services are expected to be implemented in mid-2015—just in time for companies selected for an MTC Income Tax Audit to be the test subjects. Notably, of the nine states committing seed money to the development of a multistate transfer pricing audit service, five (Alabama, Hawaii, Kentucky, New Jersey and the District of Columbia) are participating in the MTC Income Tax Joint Audit Program. It is not clear whether the two MTC-sponsored audit programs will be intertwined; however, the option was proposed this past summer and remains a possibility as we approach the upcoming audit selections.

Finally, it remains to be seen whether the MTC can audit for non-Compact states. See Gillette Co. v. Franchise Tax Bd., 147 Cal. Rptr. 3d 603 (Cal. Ct. App. 2012) review granted and opinion superseded sub nom. Gillette v. Franchise Tax Bd., 291 P.3d 327 (Cal. 2013). Audit authority stems from a provision in the compact giving the MTC authority to audit any “party state or subdivision thereof;” however, nowhere does the MTC define “party state.” The bylaws of the MTC do distinguish between party states and mere member states—affording more rights to party states. With this in mind, there appears to be a continued and unresolved argument to be made that non-Compact states (increasing by the day) are not “party states” and therefore have no authority to participate in the Joint Audit Program under the narrowly construed terms of the compact.

To participate in the public comment portion of the upcoming MTC Audit Committee meeting, dial (866) 546-3377, conference code 852212.

Practice Note: Taxpayers chosen as the subject of an MTC audit should carefully craft their audit strategy to address the unique issues raised by a multistate audit and by the MTC’s specific areas of focus. Finally, while this post has focused on income tax issues, the MTC also audits for sales tax compliance.