Indiana: Department cannot forcibly combined taxpayer with affiliates

Forced combination rules in Indiana

The Indiana Tax Court issued a decision holding that the Department of Revenue could not require a taxpayer to file a combined return with certain affiliates.


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The case is:  Rent-A-Center East, Inc. v.  Department of State Revenue, No. 49T10-0612-TA-00106 (September 10, 2015) Read the Indiana Tax Court’s decision [PDF 313 KB] 

Indiana law

Under Indiana law, separate entity filing is the default reporting methodology. However, the Department of Revenue has statutory authority to require a taxpayer to determine income from Indiana sources using an alternative method if use of the standard method does not fairly represent the taxpayer’s Indiana income (e.g., using separate accounting, excluding one or more factors, or including additional factors). 

In addition, the Department can distribute, apportion or allocate income among affiliated organizations, trades or businesses to achieve a fair reflection of income from Indiana sources. Finally, under certain circumstances the Department may require a taxpayer to file a combined return with certain of its affiliates. However, a combined return may not be required unless the Department is unable to fairly reflect the taxpayer's adjusted gross income through use of its other discretionary powers.


The taxpayer operated rent-to-own retail facilities where customers could rent tangible property such as electronics, furniture and appliances.

Following an audit, the Department assessed additional adjusted gross income tax for the 2003 tax year on the basis that the taxpayer ought to have filed a combined return with two of its affiliates. 

  • The first affiliate operated retail rent-to-own establishments in the western part of the United States and also owned the business trademarks. The taxpayer paid royalties to the first affiliate for the use of the intangibles, and these payments were deducted in computing Indiana adjusted gross income.
  • The second affiliate operated retail rent-to-own facilities in Texas and also employed upper management that performed strategic management functions for the taxpayer’s group. The taxpayer paid to the second affiliate management fees that were also deducted in computing Indiana adjusted gross income. 

Procedural history

After the assessment was upheld administratively, the taxpayer filed suit with the Indiana Tax Court. The state tax court granted summary judgment in favor of the taxpayer, holding that the Department did not present prima facie evidence that it considered alternatives to combined reporting. Rather, the Department presented reasons why applying an alternative apportionment method other than combined reporting would not be effective. The state tax court determined these were “afterthought arguments” and not “material facts.” The Indiana Supreme Court subsequently reversed, holding that a notice of proposed assessment is prima facie evidence that the Department’s claim for unpaid tax is valid. The matter then went back before to the tax court to address the parties’ motions on the merits.

Indiana Tax Court decision

The taxpayer asserted that the Department could not force it to file a combined return because its 2003 separate return fairly reflected its Indiana source income, offering as evidence an independently prepared transfer pricing study indicating that the intercompany transactions were conducted at arm’s length rates. The Department disagreed, arguing that the taxpayer must be forced to file a combined return because: (1) the taxpayer and its affiliates were engaged in a unitary business; (2) the payment (and deduction of) of royalties and management fees distorted the taxpayer’s Indiana source income; and (3) the taxpayer earned substantial profits that were not taxed in Indiana.

The Indiana Tax Court first rejected the Department’s claim that because the taxpayer was engaged in a unitary business with certain affiliates, it was automatically required to file a combined return as the only means of accurately capturing and apportioning the “unquantifiable transfers of value” flowing among the unitary entities.  Under Indiana law, taxpayers are mandated to file on a separate basis unless special circumstances require or permit a combined filing. In the court’s view, it would render Indiana’s separate-entity taxing scheme superfluous if a taxpayer could be required to file a combined return simply because it was engaged in a unitary business.

The court next addressed whether the taxpayer was required to file a combined report because the intercompany transactions with the two affiliates distorted its Indiana source income.  [Note that the Department had stipulated that the two affiliates were formed for valid business purposes.]  After a lengthy discussion, the state tax court concluded that the Department had not established that the taxpayer engaged in any improper tax avoidance measures and that the intercompany transactions were at arm’s length. As such, the taxpayer’s intercompany transactions could not be disregarded because they lacked a valid business purpose or economic substance. As noted, the taxpayer provided a 2002 federal transfer pricing study as support for its position that its intercompany transactions were arm’s length. The Department urged the tax court to disregard the transfer pricing study because: (1) it concerned financial accounting, not tax; (2) it concerned federal law; (3) it had no binding effect on state tax authorities; (4) other jurisdictions have rejected similar studies; and (5) the study itself was flawed. 

The state tax court rejected the Department’s position that the transfer pricing study was to be disregarded because it addressed accounting concerns. The study clearly stated it was based on federal income tax law and the related regulations. Next, the tax court addressed the Department’s contention that the study placed too much emphasis on the arm’s length standard required under IRC section 482, which was designed to combat offshore tax evasion by multinational companies. In the Department’s view, because Indiana has not adopted IRC section 482 and was concerned with fairly representing the taxpayer’s state tax liability, the study was not to be given weight.  The court disagreed, noting that IRC section 482 did not just address federal tax evasion, but also addressed clearly reflecting the income of related organizations. Furthermore, the court noted that Indiana Code § 6-3-2-2(m) was virtually identical to IRC section 482.  

The tax court also rejected the Department’s other arguments that the transfer pricing study was to be disregarded. Lastly, the state tax court rejected the Department’s position that the taxpayer’s income attributed to Indiana was distorted because the taxpayer saw a drop in its tax liability after the 2003 restructuring that gave rise to the intercompany expenses at issue. In the view of the court, there were reasons why the taxpayer’s liability changed from year to year, including law changes. The various factors cited to by the Department as support for its position (e.g., the taxpayer’s increase in net earnings and profits, growth in the amount of business done in Indiana, and the taxpayer’s Indiana tax rate decreasing by 100%) did not per se indicate distortion and trigger the Department’s authority to forcibly combine the taxpayer with its affiliates.   

KPMG observation

It is uncertain whether the Department will appeal. At present, Indiana taxpayers may view this case favorably, given that the Department of Revenue has consistently disregarded the existence of federal transfer pricing studies in determining the arm’s length nature of intercompany transactions. Although it is not entirely clear when combined reporting may be required, the decision appears to make clear that the Department must establish tax avoidance or lack of economic substance/business purpose before it can forcibly combine affiliates. 


For more information, contact a tax professional with KPMG’s State and Local Tax practice:

Marc Caito | +1 (317) 951-2434 |

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