Many U.S. financial institutions have a multientity structure with a bank holding company, one or more bank subsidiaries, and nonbank subsidiaries. As a result, there are a variety of recurring transactions between the companies in the group. However, banks may at times overlook the associated transfer pricing issues for state tax purposes because they file consolidated U.S. tax returns.
While domestic intercompany transactions among members of a federal consolidated return group may not have immediate implications from a federal tax perspective, there might be consequences from a state tax perspective. As domestic intercompany transactions can transfer resources among related-party affiliates located in different jurisdictions (for example, from a high-income tax state to a low- or no-income tax state), state tax authorities, especially in states that require separate filing, look closely at the intercompany transactions to ensure that such transactions are treated as if they were undertaken with an unrelated third party. States have been increasing their scrutiny of state transfer pricing issues recently, as there can be significant additional revenue collected by challenging existing intercompany arrangements. Additionally, several states have enacted legislation in recent years that disallows the deduction of certain intercompany expenses.
For those states that have adopted the guidelines established by Treasury Regulation Section 482, state tax authorities have discretionary power to challenge intercompany transactions to determine an "arm's length" transfer price. Therefore, taxpayers must follow the guidance provided in Section 482 for state transfer pricing purposes. Failure to follow the guidelines could lead to protracted and costly state transfer pricing audits that can bring significant additional tax liabilities.
Common Transfer Pricing Issues for the U.S. Banking Industry
One of the biggest distinctions that sets the banking industry apart from other U.S. industries is that it is highly regulated at both the federal and state levels, and depending on its type of charter and organizational structure, a banking organization can be subject to numerous federal and state banking regulations. Therefore, costly efforts needed to comply with regulatory requirements can have a huge influence on a bank's profitability.
Many banks operate in a highly integrated manner across their related parties and across multiple regions, and the regulations they must follow result in greater reliance on their affiliates for intercompany support. As a result, business arrangements between the related affiliates must be properly valued, as such transactions might trigger a transfer pricing audit. Moreover, U.S. banking regulations always are evolving, and the transfer pricing issues that are affected by the changing regulatory framework need to be reviewed on an ongoing basis to ensure that the new regulatory requirements are met. For example, certain key initiatives and provisions within the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) have made the level of intercompany transactions more visible. As a result, a regulated financial entity that regularly engages in transactions with its affiliates must establish proper and robust transfer pricing policies and accurately reflect the associated income earned by each party.
Regulatory and compliance officers in banks sometimes assume that the requirements of the transfer pricing regulations are met through the Federal Reserve’s Regulation W. While similar, one is not a substitute for the other. Regulation W, which implements Section 23A and 23B of the Federal Reserve Act for affiliate transactions, is the primary rule governing intercompany transactions between a bank and its related affiliates. The regulation applies to all federally insured depository institutions, from national to state banks and from trust companies to insured savings associations.
Regulation W imposes certain requirements and restrictions on the transactions between member banks and their nonbank affiliates to help prevent banks from incurring losses from intercompany transactions. Some of the requirements promulgated in Regulation W are analogous to the rules under Section 482, which regulate intercompany transactions among related affiliates for tax purposes. However, the major difference between the two regulations is that Regulation W evaluates the requirements from the perspective of the regulated entity only (such as determining if the price of the intercompany transaction is at market rate or better, irrespective of results to its nonbank affiliate). Section 482, on the other hand, evaluates whether the transaction is consistent with the arm’s length standard. Therefore, compliance with Regulation W may not necessarily satisfy requirements of Section 482 and could result in potential state tax exposure. A review of the intercompany transactions based on Section 482 would determine the extent of the exposure, if any.
Working to Comply
As banks navigate through the evolving regulatory landscape and improve their organizational infrastructure, sharing resources among related entities across borders is imperative. As states increase their transfer pricing audit activities, the financial institutions within the states must proactively review the business operations of their affiliates to verify the existence of the economic substance, implement a sustainable transfer pricing policy, and accurately reflect the data for financial and institutional reporting purposes to support the arm’s-length pricing rules. These prudent activities will help the banks address concerns in advance of state audit activities that focus on intercompany transactions.