Partnering Perspectives | Winter 2016
anticipation of using such firms to assist the participating states
with economic analysis, training and even audit selection. To
date, only five states (i.e., less than the minimum threshold of
seven) have agreed to participate: Alabama, Iowa, New Jersey,
North Carolina, and Pennsylvania.
The concern here is that states increasingly will attempt to
make adjustments with respect to transactions across the
water’s-edge. Where expanding nexus adds “taxpayers” to
the water’s-edge group, transfer pricing adjustments no longer
respect the geographical limits of the water’s-edge group
and instead recast transactions. While federal transfer pricing
adjustments are, to some extent, constrained by treaty terms
and processes such as Competent Authority, such constraints
do not apply to the states.
To further complicate the issue, there is no consensus among
states regarding whether the results of a transfer pricing audit
by the Internal Revenue Service under section 482 will be
honored by a state. For example, California law provides that
even a detailed audit by the Internal Revenue Service creates
only a presumption that those results will be applied for
California corporate tax purposes in water’s-edge audits.
Tax Haven Legislation
Another significant trend among the states is the adoption of
so-called tax haven legislation as a means of taxing additional
foreign source income by including it in the tax base of even a
water’s-edge group. Recent legislative activity on this subject
has occurred in states such as Colorado, Connecticut, Maine,
Massachusetts, Minnesota, New Hampshire, Oregon, and
Rhode Island. Such legislation expands the scope of the state
corporate tax base to include income earned by a foreign
corporation in a country that the state, by legislative action,
has defined as a tax haven jurisdiction.
While the term “tax haven” often had been legislatively defined by
the states to incorporate the definition used by the Organisation
for Economic Co-operation and Development (OECD), the
current trend seems to be away from such a blacklist approach
in favor of a criteria/factor-based approach.
The obvious concern here is a creeping legislative expansion of
the water’s-edge group. Obviously, a water’s-edge group that is
redefined to include more and more foreign operations becomes
less and less water’s-edge and more akin to mandatory worldwide
combined reporting with its panoply of inherent problems.
Developments such as the recent release of the so-called
Panama Papers may result in increased concerns at the state
level regarding operations in foreign jurisdictions and may create
more tax policy-driven impetus for this type of legislation. On the
other hand, “[t]he legal right of a taxpayer to decrease the amount
of what otherwise would be his taxes, or altogether avoid them,
by means which the law permits, cannot be doubted.” 3
Frequently, these legislative attempts to expand the water’s-edge
group involve foreign countries with major economies that are
major trading partners with the United States. For example,
Ireland, the Netherlands, Switzerland, and Hong Kong have
been under consideration at times by various states as potential
additions to the water’s-edge group under tax haven legislation.
3 Gregory v. Helvering, 293 US 465, 469 (1935)