Transfer Pricing in Transition
Mitigating state tax risk while preserving value

Although states experienced significant tax revenue growth during the COVID-19 pandemic, many experienced revenue declines in fiscal year 2024, some for the second consecutive year.¹ In response to economic downturns, state governments often intensify audit activity to raise revenue. One major focus for state tax audits has been, and will continue to be, transfer pricing, with states examining whether transactions between affiliated entities are conducted at arm’s length, an evaluation that may also involve examining the transaction’s economic substance and business purpose.²

A question arises: As states focus more on challenging intercompany transactions, can state tax efficiencies still be achieved through transfer pricing strategies? The answer is yes, if those strategies are properly implemented and consistent with state tax laws.

This article explores how intercompany transactions have been used to minimize state tax liabilities and how states have attempted to curtail the use of such strategies. As those structures became more common, states have responded by identifying their impact and enacting laws to mitigate the anticipated revenue loss. Although state taxing authorities continue to refine their tools and legislative frameworks to challenge those practices—with a growing emphasis on audits—transfer pricing strategies remain a possible avenue for tax-efficient structuring.

The Roots of Transfer Pricing Challenges

Corporate legal structures have evolved significantly in response to the demands of a globalized economy, becoming more nuanced and strategically designed. Key drivers of that evolution include the rapid growth of international markets and the strategic separation of key business functions—such as supply chains or financing—into distinct legal entities. Those structural shifts enable organizations to operate with greater agility and focus, while opening the door to more sophisticated intercompany arrangements. Common examples of such arrangements include:

• Shared service entities to centralize management, administrative, and corporate support functions to improve efficiency;
• Intercompany financing to facilitate internal loans and capital flows through short- or long-term funding arrangements at agreed interest rates; and
• Supply chain to manage production, distribution, intangible licensing, or sales/marketing activities across entities.³

However, in some cases these transactions, unlike those between independent third parties, have not taken place at true arm’s length. As a result, intercompany pricing may not have resulted in the same or similar profit margins as those typically seen in third-party dealings. For instance, services or goods exchanged between related entities might not be governed by formal contracts or invoicing, and key pricing elements, such as interest rates on intercompany loans, could lack robust, arm’s-length support.

Consider this scenario: ManufactureCo Inc., a widget manufacturer, sells its product to third-party customers for $100, generating a $25 profit per unit. However, ManufactureCo sells the same product to its affiliate, AffiliateCo Inc., for $75—just enough to cover its costs. Could an examination of such a pricing disparity by a state taxing agency raise questions about whether the transaction structure was designed to shift profits between jurisdictions? Would states view that as an attempt to arbitrarily reallocate income?

Although the Internal Revenue Service has well-established statutory and regulatory tools to challenge cross-jurisdictional profit shifting, state-level mechanisms to challenge such transactions have developed more slowly, with states continuing to strengthen their defenses against intercompany transactions.⁴

Understanding Federal Tax Principles—a Prerequisite for State Transfer Pricing

To effectively navigate state income taxation, it is essential to first understand the fundamentals of federal income tax laws. States generally use federal taxable income as the starting point for their calculations, often conforming to the Internal Revenue Code, although they are allowed to decouple from provisions they find unfavorable.⁵

Under federal tax laws, domestic corporations that are part of an affiliated group (generally defined as entities connected through eighty percent common ownership and that share a common parent) may elect to file a consolidated tax return.⁶

Generally, transactions between members of an affiliated group are eliminated or deferred for federal income tax purposes.⁷ Doing so reduces the potential for tax avoidance through transactions between member corporations.⁸ However, transactions with corporations outside the affiliated group still have the potential to be used to reduce taxable income. To address this, IRC Section 482 empowers the IRS to reallocate income, expenses, and other tax items among entities that are directly or indirectly owned or controlled by the same interests when such adjustments are needed to prevent tax evasion or clearly reflect income.⁹

From Federal to State—the Rising Complexity of State Transfer Pricing Challenges

States have their own reporting rules, which differ significantly from the federal consolidated return rules. Although some states allow corporations to file consolidated returns under specified circumstances, most states require one of two methods for corporate income tax reporting: separate company reporting (in which each corporation files its own return on a standalone basis) or mandatory unitary combined reporting (corporations that constitute a unitary business will file their state tax return as a combined group). Although transfer pricing issues are less pronounced in combined reporting states because, as with the federal rules, intercompany transactions between group members generally are eliminated or deferred, they are more prominent in separate reporting states, because those states generally do not eliminate or defer intercompany transactions. That practice in turn increases the potential for income shifting, thereby attracting greater audit scrutiny.

As of 2024, seventeen states continue to use separate company reporting, whereas most states (twenty-eight and the District of Columbia) have moved to mandatory unitary combined reporting.¹⁰ The change reflects a growing trend toward preventing income shifting through intercompany transfer pricing. Because separate reporting states generally do not eliminate intercompany transactions, intercompany transactions have historically been leveraged to report more income in lower-tax or combined reporting jurisdictions.

For example, ManufactureCo (based in North Carolina with a 2.25 percent corporate tax rate) sells unfinished widgets to AffiliateCo (in Pennsylvania with a 7.99 percent corporate rate), after which AffiliateCo completes the manufacturing process before selling to third-party customers. Selling the unfinished widgets from ManufactureCo to AffiliateCo at an artificially high price could reduce taxable income in Pennsylvania (the higher-tax state), assuming that the high transfer pricing is not reflected in higher selling prices to AffiliateCo’s customers.

Historically, state taxing agencies lacked the resources or enforcement mechanisms to evaluate whether intercompany pricing adhered to arm’s-length principles. However, that is changing: states are increasingly training auditors and investing in third-party consultants—sometimes compensated on a contingency fee basis—to review and challenge intercompany pricing arrangements more aggressively.¹¹

Several states have also enacted and enforced intercompany expense add-back statutes, disallowing deductions for intercompany expenses such as royalties or interest unless specific exceptions apply. Although the statutes vary in scope, some extend to intercompany management fees.¹²

Even without explicit statutory authority, auditors might claim the power to adjust intercompany pricing under general tax principles or by invoking IRC Section 482-like authority. Because most states conform to the IRC, in some instances state auditors assert that they have powers similar to those in Section 482 to reallocate income and expenses among related entities to prevent tax evasion or to clearly reflect income.¹³ And some states have their own versions of Section 482 that provide similar authority. Increased scrutiny has been especially visible in separate reporting states such as Alabama, Florida, Georgia, Indiana, Mississippi, and South Carolina.¹⁴

In some cases, separate reporting states have forced corporations to file on a combined reporting basis to challenge perceived income shifting through intercompany transactions. For example, even though South Carolina is a separate company reporting state, in the past its Department of Revenue (DOR) required multistate taxpayers with transfer pricing arrangements to file using combined reporting unless they could prove their intercompany arrangements fairly reflected their in-state activity. However, in March 2024, South Carolina enacted SB 298 to put more taxpayer-friendly guardrails around the DOR’s practice, narrowing the circumstances under which the DOR could require a company to file a combined report.

In another attempt to prevent tax planning through intercompany transactions, some states have moved away from separate company reporting and adopted mandatory unitary combined reporting. Today, most states with corporate income taxes require combined reporting (twenty-eight out of forty-five, as noted above), aligning to some extent with federal consolidated return principles—namely, eliminating or deferring intercompany transactions within the reporting group. That change reduces opportunities for income shifting among affiliated entities.¹⁵ Because intercompany transactions generally are removed from the state tax return, these states face less pressure to examine transfer pricing among group members. If a state tax authority challenges intercompany transactions, the focus is on transactions with entities outside the combined reporting group.¹⁶

That scenario leads to another question: Which entities are considered members of the combined reporting group? States have adopted two main approaches to unitary combined reporting: worldwide combined reporting and water’s-edge combined reporting. Most unitary combined reporting states require water’s-edge combined reporting, although some states, such as Massachusetts and New Jersey, allow taxpayers to elect to file on a worldwide combined reporting basis.¹⁷ On the other hand, a small number of states, such as California and Montana, require the use of worldwide combined reporting unless a company elects to file on a water’s-edge basis.

In worldwide combined reporting states, unitary affiliates, regardless of jurisdiction, are included in the combined report, effectively eliminating income shifting through offshore structures. Worldwide reporting has increasingly become an attractive way for states to prevent tax avoidance through intercompany transactions. Further, states have started to consider mandating the use of worldwide combined reporting without allowing the taxpayer the option to make a water’s-edge election.¹⁸ However, as of this writing, no state has enacted that type of regime.

By comparison, water’s-edge combined reporting generally includes only corporations formed in the United States, although some states require inclusion of non-US corporations if specific thresholds (such as the 80/20 rule) are met. For example, under the 80/20 rule, if a non-US entity conducts at least twenty percent of its business activities (based on property, payroll, and/or sales, depending on the state’s rules) in the United States, the combined report may include that entity. However, the combined report may exclude entities that do not meet the 80/20 rule or other state rules for inclusion. Therefore, under water’s-edge combined reporting, transfer pricing principles still apply to entities excluded from the combined reporting group.

Although New Jersey adopted mandatory water’s-edge combined reporting effective in 2019, it has acknowledged the continuing risk from intercompany transactions conducted with non-US affiliates outside the filing group. Specifically, Robert Joyce, the executive deputy director of the New Jersey Division of Taxation, said, “There can still be issues where the federal group does not align with the NJ group filing election, and there can still be transactions that are outside the NJ filing group that may impact the NJ tax liability . . . . It will always be difficult to develop the skills and knowledge within any state tax agency to deal with these complex issues.”¹⁹

The Bottom Line—Can Transfer Pricing Still Deliver Value?

Despite the growing attention from state lawmakers and auditors, structuring through related-party arrangements is still a valuable strategy to achieve tax efficiencies as long as strategies are properly implemented and consistent with state tax laws. In some circumstances, significant benefits can be realized—particularly in separate reporting states. However, to help reduce challenges by state tax authorities, the strategies must adhere to the arm’s-length standard, must be accompanied by robust transfer pricing documentation, and must be supported by written intercompany agreements that reflect the activities of the parties involved and the pricing among them.

As state audit efforts intensify, the importance of thorough documentation to support transfer pricing arrangements has never been greater. Best practices include maintaining intercompany agreements, preserving supporting documentation (for example, invoices, bank records, and journal entries), updating transfer pricing calculations periodically, recording board meetings, and consistently applying and maintaining formal transfer pricing policies. Those kinds of measures enhance audit readiness and strengthen the taxpayer’s ability to defend intercompany pricing at arm’s length if a state taxing agency challenges a transaction.²⁰

Although unitary combined reporting states eliminate or defer many intercompany transactions, thereby making domestic planning opportunities appear limited at first glance, cross-border structuring can still present some viable opportunities. For example, water’s-edge reporting states that allow inclusion of certain non-US corporations could provide benefits either by including loss entities that can offset the income of other group members or by diluting apportionment factors by including foreign receipts in the denominator of the sales factor. Importantly, for non-US corporations that are excluded from the combined reporting group, intercompany transactions with such affiliates can still create tax efficiencies if properly implemented and consistent with US federal and state tax rules.

Finally, to further mitigate the risks surrounding state examinations of transfer pricing, businesses should stay informed about the availability of voluntary disclosure or amnesty programs. Some states have recently extended olive branches to taxpayers to address transfer pricing issues, implementing voluntary disclosure programs that provide avenues for taxpayers to resolve potential exposures before formal audit activity begins. States like Louisiana, New Jersey, North Carolina, and Tennessee have adopted such initiatives; taxpayers that forgo participation could face heightened scrutiny during future examinations.²¹

Ultimately, with thoughtful planning, proper implementation, and strong documentation, taxpayers can continue to achieve meaningful tax efficiencies while navigating today’s evolving state tax landscape.

Shirley Wei and Jeremy Dukes are tax principals, and John Damin is tax managing director, all in the state and local tax practice at BDO.

Endnotes

1. Justin Theal & Greg Mennis, States Confront New Fiscal Challenges in a Post-Pandemic Landscape, Pew Charitable Trusts (November 25, 2024), www.pew.org/en/research-and-analysis/articles/2024/11/25/states-confront-new-fiscal-challenges-in-a-post-pandemic-landscape.
2. Michael J. Bologna, State Ramps Up Transfer Pricing Audits in Search of Tax Revenue, Bloomberg Tax (September 18, 2023), www.bloomberglaw.com/product/tax/bloombergtaxnews/daily-tax-report-state/X11P511O000000?bna_news_filter=daily-tax-report-state.
3. Kate Pascuzzi, Tax Strategist: State Transfer Pricing Takes Center Stage, BDO USA (March 1, 2022), www.bdo.com/insights/tax/tax-strategist-state-transfer-pricing-takes-center-stage.
4. Pascuzzi.
5. Eileen Reichenberg Sherr, Understanding State Tax Conformity, The Tax Adviser (June 1, 2024), www.thetaxadviser.com/issues/2024/jun/understanding-state-tax-conformity/.
6. See IRC Section 1563(a)(1) – (3).
7. See 26 CFR Section 1.1502-13.
8. Pascuzzi.
9. Anthony Diosdi, The Taxation of Affiliated Corporations and Computing Consolidated Taxable Income, Diosdi & Liu, LLP (November 13, 2023), https://sftaxcounsel.com/blog/the-taxation-of-affiliated-corporations-and-computing-consolidated-taxable-income/.
10. Corporate Income Tax Filing Methods: States With Water’s Edge or Worldwide Combined Reporting, Institute on Taxation and Economic Policy (February 21, 2025), https://itep.org/states-with-waters-edge-or-worldwide-combined-reporting/.
11. Pascuzzi.
12. Charles F. Barnwell Jr., Addback: It’s Payback Time, State Tax Notes (November 7, 2008), http://barnwellco.com/media/article3.pdf.
13. Sowmya Varadharajan & Mike Santoro, State Transfer Pricing Cases Show Importance of Documentation, Bloomberg Tax (October 28, 2024), www.bloomberglaw.com/product/tax/bloombergtaxnews/tax-insights-and-commentary/XDMIMUS000000?bna_news_filter=tax-insights-and-commentary.
14. Bologna.
15. Bologna.
16. Kathryn E. Rice, The Challenges of State Transfer Pricing, The Tax Adviser (September 1, 2010), www.thetaxadviser.com/issues/2010/sep/clinic-story-09-sep-2010.
17. Ilya Lipin & John Damin, State Income Tax Considerations for Non-US Companies, The Tax Adviser (May 1, 2024), www.thetaxadviser.com/issues/2024/may/state-income-tax-considerations-for-non-us-corporations.
18. Douglas L. Lindholm & Marilyn A. Wethekam, Mandatory Worldwide Combined Reporting: Elegant in Theory but Harmful in Interpretation (March 2024), www.cost.org/globalassets/cost/state-tax-resources-pdf-pages/cost-studies-articles-reports/wwcr-article—final.pdf.
19. Bologna.
20. Bologna.
21. Bologna.