ExxonMobil Oil Corporation, Hess Corporation, and Shell Oil Company (collectively, the “Oil Companies”) were recently dealt another blow in their ongoing transfer pricing dispute with the District of Columbia Office of Tax and Revenue (“OTR”). The Oil Companies are among several taxpayers that have been fighting the validity of the transfer pricing methodology employed by Chainbridge Software LLC (“Chainbridge”), the OTR’s third-party transfer pricing consultant. Just last year, the Oil Companies unsuccessfully sought to estop the OTR from relitigating the validity of the controversial Chainbridge methodology in light of the OAH’s holding in Microsoft Corp. v. Office of Tax and Revenue (2012) that the Chainbridge methodology was arbitrary, capricious and unreasonable (for prior coverage, see DC Office of Tax and Revenue Set to Relitigate Chainbridge Methodology in Oil Company Cases). In a January 26, 2018 Order, Office of Administrative Hearings (“OAH”) Administrative Law Judge Bernard H. Weberman denied the Oil Companies’ motion for summary judgment, holding that they failed to establish that the transfer pricing method employed by Chainbridge was arbitrary, capricious and unreasonable as a matter of law. Hess Corp., et. al. v. D.C. Office of Tax & Revenue, Case Nos. 2012-OTR-00027, 2011-OTR-00047, 2011-OTR-00049 (Jan. 26, 2018).

The Oil Companies asserted that the OTR’s assessments were arbitrary and capricious on the basis that Chainbridge improperly applied the comparable profits method (“CPM”)—whereby Chainbridge compared each of the Oil Company’s profit-to-cost ratios against the profit-to-cost ratios of third parties it deemed to be comparable—concluding that the Oil Companies’ intercompany transactions were not priced at arm’s length. The Oil Companies specifically objected to the Chainbridge analysis on three separate grounds—all of which were rejected by Judge Weberman.

First, the Oil Companies asserted that Chainbridge failed to separate related party (“controlled”) transactions from third-party (“uncontrolled”) transactions when determining their profit-to-cost ratios. In response, Judge Weberman concluded that a comparison of financial data from controlled transactions to uncontrolled transactions is only required “to the extent possible” under the CPM, and, because Chainbridge concluded that separating out the controlled and uncontrolled transactions was not possible, the failure to compare controlled transactions and uncontrolled transactions was not unreasonable, arbitrary, or capricious. Judge Weberman further held that the accuracy of Chainbridge’s conclusion in that regard was a question of fact that warranted further factual development.

Second, the Oil Companies argued that Chainbridge erroneously applied the CPM at the entity level, thereby aggregating multiple product lines with different functions, and instead should have evaluated each of the Oil Company’s related products and business segments on a separate basis. Stating that “there are practical limits to what a taxing authority can do in making comparisons,” Judge Weberman held that the question of whether a more granular analysis is needed is “inherently a question of fact.”

Finally, the Oil Companies objected that Chainbridge’s analysis did not allow for “correlative allocations,” i.e., downward adjustments to the income of other members of the Oil Companies’ controlled group affected by the OTR’s “primary allocation” (i.e., the adjustment increasing the income of the Oil Companies). Because primary allocations are not considered to have been made under the federal section 482 regulations (which interpret section 482 of the Internal Revenue Code, upon which the OTR’s transfer pricing authority is based) until “the date of a final determination with respect to the allocation,” Judge Weberman held that correlative allocations were not required.

Implications

In an unexpected turn of events, Judge Weberman’s order now conflicts with the outcome of the Microsoft case, in which summary judgment was granted in favor of Microsoft on similar grounds as those advanced by the Oil Companies. As a next step, Judge Weberman directed the parties to reevaluate their settlement positions and exhaust all settlement possibilities before the next status conference in the matter, which is currently scheduled for March 7, 2018. In the meantime, matters involving similar taxpayer challenges that had been stayed pending the outcome of Hess Corp., et al. v. D.C. Office of Tax and Revenue are now moving forward.

Despite this setback and pending the ultimate resolution of the Oil Company cases, taxpayers are encouraged to continue challenging OTR assessments that are based on Chainbridge’s faulty transfer pricing methodology. There appears to be a renewed interest by some states in joining the OTR in using third-party consultants, including consultants who are paid on a contingency fee basis, for transfer pricing matters. For example, Rhode Island has been aggressively pursuing transfer pricing issues with a number of taxpayers based on transfer pricing analyses conducted by a third-party consultant. Similarly, Mississippi is currently exploring the use of third-party consultants following recent legislation that expressly allows the use of contingent fee auditors in tax matters. As state tax authorities increase their reliance on outside consultants in transfer pricing matters, taxpayers must continue to challenge questionable methodologies and analyses to ensure that such outside consultants, particularly consultants who are compensated with contingency fee arrangements, are used to assist state tax authorities in determining the correct (as opposed to the highest) tax due.