The Utah Supreme Court handed taxpayers a victory on October 5, 2018 when it issued a unanimous (5-0) decision in the closely-watched Utah State Tax Commission v. See’s Candies, Inc., 2018 UT 57 (Oct. 5, 2018). The Court affirmed the district court’s holding that the Utah State Tax Commission’s (“Commission”) discretionary authority to reallocate a taxpayer’s income under Utah Code Section 59-7-113 (“Section 113”) is limited by the “arm’s-length” standard set forth in the federal treasury regulations interpreting Section 482 of the Internal Revenue Code (“IRC”). For a discussion of the district court decision and the oral argument before the Utah Supreme Court, see Keeping the State at Arm’s Length: State Transfer Pricing Recent Developments and Utah See’s Revenue, Ignores Transfer Pricing, respectively. See’s Candies, which is the latest among several recent high-profile state and local transfer pricing cases (see, e.g., DC Office of Tax and Revenue Set to Relitigate Chainbridge Methodology in Oil Company Cases and Summary Judgment Denied (Again) in District of Columbia Transfer Pricing Cases) highlights the ongoing efforts of state taxing authorities to target intercompany pricing, and underscores the importance for taxpayers of supporting their intercompany transactions with independent transfer pricing studies.
To recap, See’s Candies, Inc. (“Taxpayer”) sold certain intellectual property (“IP”) to an affiliate, Columbia Insurance Company (“Columbia”). Taxpayer paid Columbia a royalty to use the IP and deducted the royalty payment from its income as a business expense. The Commission denied Taxpayer’s entire royalty expense deduction pursuant to Section 113—Utah’s analog to IRC § 482—which permits the Commission to allocate income between two or more related corporations if the allocation is “necessary in order to prevent evasion of taxes or clearly reflect the income of any of such corporations” (emphasis added). The Commission dismissed Taxpayer’s transfer pricing documentation, which supported the arm’s length nature of the royalty payments (based on IRC § 482 principles), as irrelevant. At the district court, the Commission asserted that an adjustment under Section 113 is appropriate whenever the Commission, in its sole discretion, deems such an adjustment “necessary.” Taxpayer argued that the Commission may only adjust income under Section 113 if the transaction does not satisfy the “arm’s length” standard of IRC § 482 and the accompanying Treasury regulations. The district court found in favor of the Taxpayer, and the Commission appealed.
In upholding the district court’s determination, the Court relied in part on the legislative history of IRC § 482, which revealed that the phrase “necessary in order to prevent the evasion of taxes or clearly to reflect … income” meant that “allocation would be necessary in circumstances when businesses engage in transactions that parties dealing at arm’s length would not enter” (emphasis added). This “arm’s length” concept, the Court held, was intended by the Utah Legislature to be incorporated into Section 113 by virtue of the Legislature adopting language nearly identical to IRC § 482. In addition, the Court examined other state approaches to statutory construction and concluded that where a state law is modeled after an existing federal statute, federal interpretations serve as persuasive authority in construing the analogous state law. The court further reasoned, based on its own case law, that “use of similar language indicates a legislative intent to adopt not just the language of a federal statute, but also its accompanying ‘cluster of ideas.’” Due to the “striking similarity” between IRC § 482 and Section 113, and because the two statutes share similar functions, the Court concluded that allocation is “necessary” under Section 113 only when “related companies enter into transactions that do not resemble what unrelated companies dealing at arm’s length would agree to do.” Because the Commission did not challenge the district court’s factual finding that the royalties paid by Taxpayer were arm’s length, the Court upheld the district court’s decision.
See’s Candies is an important case because it supports looking to federal authorities for interpretive guidance regarding analogous state statutes in the absence of other state authority—a tool of statutory construction that state departments of revenue have pushed back on when it does not suit them. More specifically, however, the decision may serve as a check on state taxing authorities (in Utah and elsewhere) seeking to expand their discretionary authority to reallocate income among related corporations beyond the contours of IRC § 482.
