Remember in high school, when you knew the answer to a complicated math question but still got dinged on your exam because you didn’t show your work?

That’s pretty much what happened earlier this month when the D.C. Office of Administrative Hearings granted summary judgment in favor of Microsoft Corp. Inc., who had challenged a corporate franchise tax assessment based on a shorthand third-party transfer pricing analysis.

I’ll be the first to admit that transfer pricing is a pretty complex area of tax law.  Embodied in Code Section 482 and its voluminous related regulations is the concept that taxpayers engaging in transactions with controlled or affiliated entities must price those transactions according to an “arm’s length” standard.  In short, a related party transaction must be “consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.”  Treas. Reg. § 1.482-1(b)(1).  Transfer pricing analysis has particular importance in international taxation since it would be theoretically very easy to move money to a low-tax jurisdiction by simply doing business with a controlled entity formed in that jurisdiction.  Section 482’s regime is meant to address that potential abuse.

In this case, the District of Columbia assessed approximately $12.75 million in tax against Microsoft for its 2006 fiscal year based on a contracted transfer pricing analysis performed by Chainbridge Software Inc.  Chainbridge analyzed Microsoft’s profit-to-cost ratio and compared it with other profit-to-cost ratios to measure Microsoft’s controlled transactions against the arm’s-length standard.  However, Microsoft pointed out that Chainbridge’s analysis failed in a number of ways:

1. Chainbridge failed to isolate Microsoft’s controlled transactions from its third party dealings.  Under the Section 482 regulations, the comparable profits method requires an examination of only controlled transactions;
2. Chainbridge improperly aggregated all of Microsoft’s transactions, even though the transfer pricing regulations require a taxpayer’s transactions to be separated based on type and business line; and
3. Perhaps most importantly, Chainbridge did not perform an actual audit of Microsoft’s books and records.  Instead, it built its analysis on Microsoft’s D.C. tax returns and publicly available information.  Chainbridge did not scrutinize any particular intercompany transaction or type of transaction and instead, it simply reviewed Microsoft’s total sales and other income, cost of goods sold, and total deductions to determine Microsoft’s net-profit-to-sales ratio.

In short, Chainbridge was a little lazy.  Creative, perhaps, but lazy.  In fact, D.C. essentially lampshaded its own shortcomings by arguing that Microsoft’s business structure was so complex that complete aggregation was the only way it could be analyzed.

While acknowledging that Microsoft has at least 100 affiliated businesses and has had thousands of inter-company transactions, the D.C. Office of Administrative Hearings dismissed this argument, noting that “the fact that Microsoft has 100 or even 2,000 affiliates does not address the question of why there was no effort to isolate the controlled transactions.”  In the end, the administrative panel found that Chainbridge’s analysis was “useless in determining whether Microsoft’s controlled transactions were conducted in accordance with the arm’s-length standard” and its findings were “arbitrary, capricious, and unreasonable.”

This case’s resolution should provide some healthy ammunition for any other multi-jurisdictional entity facing a similar broad application of transfer pricing concepts.  Foreign, state, and municipal entities who contract out their transfer pricing audits to private entities will need to keep this result in mind.  Indeed, any such sovereign should seriously investigate the vendor’s methods before agreeing to pay for these services.

Because you’ve got to check your work.

UPDATE:  And due to demand, you can now read the final order in its entirety.

Photo courtesy of  Svadilfari