The Utah Tax Court recently issued its decision in See’s Candies, Inc. v. Utah State Tax Commission, Case No. 140401556, holding that the “arm’s-length” standard set forth in the federal treasury regulations relating to section 482 of the Internal Revenue Code (“IRC”) controls for purposes of guiding the Utah State Tax Commission (“Commission”) in reallocating income pursuant to Utah Code section 59-7-113 (“Section 59-7-113”), which is nearly identical to section 482 of the IRC.

Summary of Facts

See’s Candies, Inc. (“Taxpayer”) is a multi-state retailer with physical locations in Utah. In 1997, Taxpayer’s affiliate (“Affiliate”), an out-of-state insurance company subject to the Utah premiums tax, purchased from Taxpayer certain  trademarks and other intellectual property (“IP”) in exchange for stock.  Taxpayer and Affiliate entered into an agreement under which Taxpayer was required to make quarterly royalty payments to Affiliate for the use of the IP.  The parent company of Taxpayer and Affiliate hired a team of economists to value Taxpayer’s IP and Affiliate’s stock to ensure the initial transfer and ongoing royalty payments would meet the arm’s-length standard in the federal treasury regulations regarding IRC section 482.  From January 1, 1999 through December 31, 2007 (“Years at Issue”), Taxpayer deducted from its income the royalty payments made to Affiliate for its use of the IP.  Because Affiliate was only subject to tax in Utah on the premiums it collected, it did not pay Utah tax on the royalties received from Taxpayer.

Relying on Section 59-7-113, the Commission disallowed the entire amount of Taxpayer’s royalty expense deductions for the Years at Issue based on its conclusion that the deductions constituted an “improper shifting of income” between Taxpayer and Affiliate. The Commission did not consider Taxpayer’s transfer pricing documentation or the arm’s-length standard in reaching its determination.

Summary of Opinion

The Utah Tax Court acknowledged that the Commission enjoys broad discretion to adjust income under Section 59-7-113; however, the Tax Court recognized that such discretion is not unlimited. While the Commission argued that it’s exercise of discretion is subject to only an “abuse of discretion” standard, the Tax Court aptly noted that even an abuse of discretion standard “requires there be some law to apply to see if allowable discretion has been exceeded and to avoid arbitrariness and capriciousness.”  Looking at the statutory scheme as a whole, the Tax Court noted that Section 59-7-113 itself gives “no clear directive” as to how the Commission should reallocate income among related corporations and the Commission has not promulgated any rules on the subject.  As a result, the Tax Court, noting that Section 59-7-113 is almost identical to IRC section 482, agreed with a 1979 informal Utah Attorney General Opinion, which found that “[i]n adopting [language identical to IRC § 482], Utah made an affirmative determination that it would adopt federal interpretation on the subject.”

Accordingly, the Tax Court held that federal regulations and interpretations of IRC section 482—in this case, the arm’s-length standard—should apply for purposes of defining the Commission’s authority to reallocate income under Section 59-7-113. Thus, the Tax Court concluded that it was an abuse of discretion for the Commission to deny the royalty expense deductions entirely rather than analyze them under federal arm’s-length standards.  Because Taxpayer had introduced unrebutted testimony regarding the valid business purposes for the transactions at issue and had established, through a transfer pricing study and expert testimony, that the royalty rate was within an arm’s-length range of rates, the Tax Court concluded that the royalty expenses were deductible (albeit subject to a 10% reduction to align the royalty amount with the lowest end of the arm’s-length range presented by Taxpayer).

The Commission has appealed the Tax Court’s decision.


The Commission’s position that it had unbridled discretion to adjust (and, as a result, completely disallow) deductions for expenses paid to related parties is the latest example of what appears to be a nationwide trend in state transfer pricing audits.

For example, the Indiana Department of Revenue (“Department”) has historically attempted to adjust intercompany transactions based on bald assertions of distortion and has similarly argued that IRC section 482 and its regulations (including the arm’s-length standard) did not apply for purposes of applying Indiana’s section 482-type statute.  The Department had further refused to acknowledge the relevance of transfer pricing studies prepared based on IRC section 482 principles to Indiana transfer pricing determinations.  However, following two Indiana Tax Court decisions, Rent-A-Center East, Inc. v. Indiana Department of State Revenue, 42 N.E.3d 1043 (Ind. Tax Ct. 2015) and Columbia Sportswear USA Cop. v. Indiana Department of State Revenue, 45 N.E.3d 888 (Ind. Tax Ct. 2015), holding that the federal “arm’s-length standard is relevant for evaluating whether intercompany transactions … distort the true generation of income” for Indiana income tax purposes, the Department finally acknowledged in a recent Letter of Findings (Letter of Findings No. 02-20150117) the appropriateness of the arm’s-length standard as well as the relevance of transfer pricing studies when evaluating the arm’s-length nature of transactions between related parties.  Commendably, the Department held that a taxpayer’s transfer pricing study cannot be set aside unless the Department can show its shortcomings with “sufficient specificity.”  In other words, ambiguous or bald assertions are not enough to reject a taxpayer’s transfer pricing study and reallocate income between related parties.

As states continue to focus on related-party transactions and attempt to expand the boundaries of their discretionary authority to reallocate income among related parties, taxpayers should continue to vigorously object to unsupported adjustments and point to these recent Utah and Indiana cases for support.

Contact the Authors: Lindsay LaCava, Michael Tedesco