By Todd Betor and Andrew Appleby

The Indiana Department of Revenue issued a Letter of Findings denying a taxpayer’s deductions for certain intercompany payments to a subsidiary management company. The taxpayer and its subsidiary management company (Management Co.) entered into an intercompany agreement based on a federal income tax transfer pricing study, which endorsed the “residual profit method.” Under the residual profit method, in addition to general payment for expenses and operating costs, the taxpayer paid Management Co. a “residual profit” beyond the “routine profit” that is customary in that business line. The taxpayer deducted the intercompany payments, including residual profits, for Indiana tax purposes. The Department denied the taxpayer’s deduction for the residual profits paid to Management Co, arguing that Indiana Code § 6-3-2-2(m) is synonymous with I.R.C. § 482, so Indiana must permit the deduction that was allowed for federal purposes. The Department focused on the potential windfall for the taxpayer based on circular cash flow. Although there was no actual circular cash flow, the Department posited hypothetical scenarios that could potentially create circular cash flow.  Therefore, the Department determined that the taxpayer’s residual profits deduction did not reflect the taxpayer’s economic realities and denied the deduction. Ind. Dep’t of State Rev., Ltr. of Findings No. 02-20120310 (July 1, 2013).