Beleaguered D.C. Taxpayers Achieve Another Success in Ongoing Challenges to the Methodology Used in the District’s Transfer Pricing Audit Program
Thursday, November 20, 2014

On Friday, November 14, 2014, an administrative law judge (ALJ) issued three identical orders granting the taxpayer’s motion for summary judgment in Hess v. OTRShell v. OTR and ExxonMobil v. OTR.  In these orders, the ALJ determined that based on an early ruling that the challenged methodology was fatally flawed, the Office of Tax and Revenue was barred from re-litigating the issue in the current cases under the doctrine of non-mutual collateral estoppel.

Transfer Pricing Implications

The transfer pricing litigation in D.C. has been a frustrating road for taxpayers because the flaws in the methodology OTR applied have been apparent from the outset.  The first case to be litigated wasMicrosoft v. OTR, OAH Case. No. 2010-OTR-00012 (May 1, 2012).  In this case, an ALJ ruled that the methodology the District used was fatally flawed because the methodology  failed to (i) separate controlled from uncontrolled transactions and (ii) individually analyze different product lines and different functions.  As a result, the ALJ concluded that the analysis was flawed, arbitrary and unreasonable.  OTR initially appealed the Microsoft order to the D.C. Court of Appeals, only to withdraw shortly after by filing a motion to dismiss its own petition for review.

When Microsoft was decided in 2012, it appeared that the faulty transfer pricing methods used by the District had been permanently debunked.  Nevertheless, OTR renewed the contract for the business performing the transfer pricing audits and did not materially modify the assessment methods.  As a result, taxpayers continued receiving assessments from the OTR based on the same methodology previously ruled invalid in Microsoft.  At least 10 taxpayers have challenged these assessments post-Microsoft, and the orders issued Friday are the first of these challenges to be resolved by the Office of Administrative Hearings (OAH).

The taxpayers in the Hess/Shell/ExxonMobil cases all challenged the substantive validity of the assessment methodology and argued that the Microsoft decision should be controlling.  OTR asserted that the doctrine of non-mutual collateral estoppel did not apply to the government and, even if it did, the elements were not met in this case.  The ALJ disagreed with OTR’s analysis and found “the failure to apply [non-mutual collateral estoppel] would allow [DC] to keep issuing proposed assessments to taxpayers using the same flawed Chainbridge analysis, with the hope that some taxpayers won’t have the wherewithal to challenge the assessment and will find it economically advantageous to simply pay rather than fight.”

The three orders issued on Friday should provide a definitive signal to OTR that the method is flawed as a matter of law and cannot be validly used to assess D.C. taxpayers going forward.  These decisions are essentially decisions on the merits for the pending cases and, assuming no appeal is filed, D.C. should face sanctions if it continues to pursue assessments using the methodology at issue in these cases.

Broad Implications

Perhaps more importantly than the narrow (but important) transfer pricing issue in these decisions, OAH has made is clear that non-mutual collateral estoppel can be applied against OTR in any tax case as long as the elements of the doctrine are met.  This gives real weight and importance to OAH as a venue for resolving complex tax questions.

Up Next?

The OTR has until December 15, 2014 to appeal to the D.C. Court of Appeals.  In addition to the transfer pricing cases already resolved, five cases are still pending before the OAH challenging D.C.’s transfer pricing methods.

Eric Carstens contributed to this article.

 

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