Transfer pricing has occupied the state tax spotlight in recent years, as taxing authorities continue to challenge intercompany transactions (see âKeeping the State at Armâs Length: State Transfer Pricing Recent Developmentsâ for prior coverage of state transfer pricing developments). Because state revenue departments often lack the resources and expertise necessary to perform a thorough transfer pricing audit, some states have engaged third-party service providersâoften on a contingent-fee basisâto conduct transfer pricing examinations or to prepare transfer pricing reports and analyses on their behalf. The District of Columbia Office of Tax and Revenue (âOTRâ) is one example of a local taxing agency that has for years relied on a third-party âexpert,â Chainbridge Software LLC (âChainbridgeâ), to perform transfer pricing analyses.
Recently, ExxonMobil Oil Corporation (âExxonâ), Hess Corporation (âHessâ), and Shell Oil Company (âShellâ) (collectively, the âOil Companiesâ) suffered a setback in their fight against the OTRâs reliance on the controversial transfer pricing methodology employed by Chainbridge. On March 15, 2017, the District of Columbia Office of Administrative Hearings (âOAHâ), in Hess Corporation, et al. v. Office of Tax & Revenue, Case Nos. 2012-OTR-00027, 2011-OTR-00047, 2011-OTR-00049 (D.C. Office of Admin. Hearings March 15, 2017), declined to apply the doctrine of offensive non-mutual collateral estoppel to the OTR and denied the Oil Companiesâ Motion for Summary Judgment. The Oil Companies had argued that the doctrine precluded the OTR from relying on Chainbridgeâs transfer pricing methodology because the OAH had previously determined in Microsoft Corp. v. Office of Tax and Revenue, Case No. 2010-OTR-00012 (D.C. Office of Admin. Hearings May 1, 2012), that the Chainbridge methodology was âarbitrary, capricious, and unreasonable.â However, the OAH held that âexceptional circumstancesâ for application of the doctrine against a government agency did not exist.
Background: The Microsoft Case
In 2010, Microsoft Corporation, Inc. was assessed additional franchise tax based on a transfer pricing analysis performed by Chainbridge (the âChainbridge Methodologyâ), which purported to rely on the comparable profits method set forth in the federal U.S. treasury regulations. In 2012, in Microsoft Corp. v. Office of Tax and Revenue, the OAH held that the Chainbridge Methodology was arbitrary, capricious, and unreasonable and thus cannot form the basis for a determination that the OTR may reallocate income between Microsoft and its affiliated businesses. Specifically, the OAH noted that a transfer pricing analysis under the comparable profits method compares the profit-to-cost ratio for transactions between related partiesâknown as âcontrolled transactionsââagainst the ratio for uncontrolled transactions made at armâs length with unrelated parties. The OAH concluded that in contrast to established practice, and in violation of the federal regulations, the Chainbridge Methodology improperly considered all of Microsoftâs transactions, whether controlled or uncontrolled, in analyzing Microsoftâs profit-to-cost ratio and failed to compare specific types of transactions conducted by Microsoft to uncontrolled transactions. The OTR appealed the decision, but later withdrew its appeal.
The Oil Companies Cases
In 2011, while Microsoft was pending, the Oil Companies were each assessed additional corporate franchise tax by the OTR. As in Microsoft, the Chainbridge Methodology formed the basis for the assessments. After Microsoft was decided, the Oil Companies filed motions for summary judgment invoking offensive non-mutual collateral estoppelâa common law doctrine intended to preclude a person from relitigating legal or factual issues decided in a prior proceedingâto prevent the OTR from relitigating the validity of the Chainbridge Methodology. On November 14, 2014, the OAH granted summary judgment in favor of the Oil Companies, holding that the OTR was collaterally estopped from relitigating the validity of the Chainbridge Methodology. The OTR filed an appeal with the District of Columbia Court of Appeals.
On June 30, 2016, in Office of Tax and Revenue v. ExxonMobil Oil Corporation, 141 A.3d 1088 (D.C. 2016), the Court of Appeals held that the OAH abused its discretion in collaterally estopping the OTR. The Court of Appeals noted that ââ[e]stoppels against the public are little favoredâ and âshould not be invoked except in rare and unusual, or exceptional, circumstancesââ and remanded the case back to the OAH for further proceedings to determine whether exceptional circumstances existed for the doctrineâs application.
On remand, in its March 15, 2017 order, the OAH held that, even though the parties mutually agreed to a stay in the Oil Company Cases pending the outcome of the Microsoft case because the outcome of an appeal in Microsoft was âpotentially outcome determinative precedent,â the Microsoft outcome did not meet the âexceptional circumstancesâ standard because:
- there is no binding doctrine of estoppel requiring the OTR to continue prosecuting its appeal in Microsoft;
- the unappealed outcome in Microsoft does not create a binding precedent on other similar cases before the OAH; and
- any reliance on a hypothetical ruling by the Court of Appeals is speculative.
The OAH also noted that the Oil Companiesâ potential liability for interest should the OTR prevail did not constitute an injury to support a finding of exceptional circumstances.
Implications
The OAHâs denial of the Oil Companiesâ motion for summary judgment sets the stage for the parties to proceed with litigating the merits of the case, where the parties will presumably challenge the validity of the Chainbridge Methodology on grounds similar to the Microsoft case. The Oil Companiesâ decision also has immediate implications for taxpayers with similar actions currently pending before the OAH that had been stayed pending a resolution of the offensive non-mutual collateral estoppel issue and that will now likely move forward. The OAHâs decision, along with the OTRâs continued use of Chainbridge in its transfer pricing examinations, are likely to cause consternation among taxpayers facing transfer pricing audits in the District. However, in light of the Microsoft decision, taxpayers are advised to continue challenging OTR transfer pricing assessments that are based on the Chainbridge Methodology determined to be faulty in Microsoft.
Contact the Authors: Lindsay M. LaCava, Michael C. Tedesco