Transfer pricing isn’t just for multinationals. Cannabis enterprises doing business solely within the U.S. must consider the IRS’s authority to reallocate transactions and the Treasury regulations governing intercompany service rules.
Why cannabis taxpayers should care about transfer pricing
Tax code Section 482 gives the IRS the authority to reallocate income and deductions among commonly-controlled business in order to prevent evasion of taxes or clearly reflect the income of the businesses.
Section 482 is one of most powerful weapons the IRS has as its disposal. It has had a number of significant victories recently in increasing tax liabilities for large multinational corporations, in some cases by billions of dollars. However, Section 482 applies to domestic corporations that are commonly controlled as well. For an affiliated group filing a consolidated return, there is little impact to transfer pricing adjustments for intercompany transactions. But, in the cannabis industry, consolidated returns are infrequently encountered for reasons discussed below.
Taxpayers in cannabis enterprises are subject to Section 280E denying all deductions and credits with respect to cannabis-touching trades or businesses. However, cost of goods sold is considered a reduction in gross income rather than a deduction, and 280E taxpayers are allowed to reduce taxable income by allocating certain inventory-related expenses to cost of goods sold. Broadly speaking, cannabis taxpayers thus have two tax goals: (1) separate activities subject to 280E from non-280E activities, and (2) maximize allocation of expenses to cost of goods sold calculations.
It is therefore to be expected that the IRS will use its broad transfer pricing authority to attack taxpayer arrangements with respect to these goals, especially as cannabis commerce is increasingly conducted by large corporations with complex organizational structures. Also, as cannabis companies are increasingly engaged in foreign operations, traditional transfer pricing considerations become relevant.
Some believe that filing a consolidated return puts pressure on the separation of activities into 280E and non-280E entities, and 280E is cited as one reason that cannabis companies generally do not file consolidated returns. It is worth noting that it is unclear that this strategy is effective against an IRS challenge that the entities are economically interdependent and the entire controlled group is subject to 280E. Presumably a key element of a defense against such an assertion is demonstrating that the relationships among the controlled entities conform to transfer pricing rules.
Transactions subject to transfer pricing reallocation
The cost of goods sold of a cannabis taxpayer may be determined in a related party sale, because the retailer is supplied by the manufacturer, who is supplied by the grower. The cost at which these goods are transferred is subject to scrutiny under Section 482.
In addition, a part of the organization of cannabis companies is frequently one or more subsidiaries rendering services (a “serviceco”) to the operating subsidiaries. Services are subject to a separate set of rules under Section 482. This article will focus on the special rules for pricing intercompany services. A related issue outside the scope of this article is that transfer pricing also has consequences for state and local tax regimes using other methods to allocate income and expenses. It should also be noted that a broader range of services is subject to capitalization by cannabis-touching entities that are engaged in growing and manufacturing activities as opposed to retail activities.
If services are rendered to a 280E entity at too low a price, the IRS could employ a transfer pricing reallocation to increase the fees paid for the services. If the service fees cannot be capitalized by the payor, there will be an increased disallowed deduction matched by increased taxable income to the recipient.
Conversely, if services are rendered to a 280E entity at too high a price, the IRS could employ transfer pricing analysis to assert that the service provider is actually profiting from trafficking in cannabis and is therefore subject to 280E disallowance of deductions.
Intercompany service rules
Turning now to the regulations that govern intercompany services, Treasury Regulation 1.482-9(l) is a good starting point because it defines what constitutes a “controlled services transaction.” This term:
“includes any activity . . . by one member of a group of controlled taxpayers (the renderer) that results in a benefit . . . to one of more members of the controlled group (the recipient(s)).”
“Includes any functions, assumptions of risks, or use by a renderer of tangible or intangible property or other resources, capabilities, or knowledge, such as knowledge of and ability to take advantage of particularly advantageous situations or circumstances.”
A benefit exists if:
“The activity directly results in a reasonably identifiable increment of economic or commercial value that enhances the recipient’s commercial position, or that may reasonably be anticipated to do so. An activity is generally considered to confer a benefit if, taking into account the facts and circumstances, an uncontrolled taxpayer in circumstances comparable to those of the recipient would be willing to pay an uncontrolled party to perform the same activity on either a fixed or contingent payment basis, or if the recipient would otherwise have performed for itself the same activity or a similar activity.”
It is not a complex series of questions that needs to be considered. Is there an intercompany activity? Is the activity beneficial to the service recipient? How much would a third party have paid to get that benefit? Stated differently, what exactly does the management in the serviceco do, and does it possess knowledge that could be sold?
Happily, there are some straightforward answers to these questions. The industry is one that involves very significant and non-obvious risks, and these risks may vary from state to state, each state being a separate and unique market. Figuring out what to do and what to not do in the face of a changing business environment is clearly beneficial to a service recipient, and given the risk of a business failure, an arm’s-length service provider with an established record could command significant fees.
The drafters have also steered the discussion to knowledge, particularly “knowledge of and ability to take advantage of particularly advantageous situations or circumstances.” The legalization of cannabis by a state is, it would be argued, a “particularly advantageous situation” because a legal market that never previously existed is created at the stroke of a pen, and knowing how to take advantage of this opportunity fits like a glove into the definition of an activity.
This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.
David Merrick is Tax Advisor at Riverbank Consulting LLC. He has worked extensively with transfer pricing issues pertaining to services in the financial services and technology industries. In addition, he has represented clients in tax controversies involving intercompany transactions.
James B. Mann is the owner of the Law Office of James B. Mann. His current areas of focus are the taxation of cannabis enterprises and general tax accounting issues.
Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.