4/17/2015
Intercompany Transactions
Add-back Provisions
Where Are We Now?
April 23, 2015
Presented By Andres Vallejo and Brian Kirkell
Presenters
• Andres Vallejo
• Brian Kirkell
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Morrison Foerster
[email protected]
McGladrey LLP
[email protected]
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Background
• Legislative Responses to Tax-Motivated Transactions
• Separate v. Combined Reporting
• Disallowance of related-company expense deductions
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Statutory Issues
• Requires a taxpayer to add-back certain expenses directly or
indirectly paid to a related member that is not itself subject to tax
within the taxing state, provided that a specific safe harbor is not met
• Expenses subject to add-back
• Intangible interest expenses
• Intangible expenses (e.g., patents, copyrights, trademarks, etc.)
• Embedded intangibles
• Management fees
• Definition of related member
• Generally expansive, direct or indirect common ownership of 50% of value
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Statutory Issues
• Common safe harbors
• Transaction has a valid business purpose and economic substance, and is
undertaken at arm’s length rates & terms
• Principal purpose for the transaction was not tax avoidance
• Recipient pays an income-based tax to one or more other states on the
income received from the related party taxpayer
• Recipient not “primarily engaged” in maintenance and management of
intangibles
• Recipient is located in a foreign country that has a comprehensive tax treaty
with the U.S.
• Expense has a valid business purpose and is ultimately passed through to an
unrelated party
• Taxpayer and state enter into alternative apportionment agreement
• Taxpayer and recipient are included in a combined or consolidated report
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Significant Cases
• Surtees v. VFJ Ventures, Inc., 8 So. 3d 950 (Ala. Civ. App. 2008)
• Taxpayer jeans manufacturer licensed trademarks from related member Delaware
intangibles management company
• Alabama Court of Civil Appeals required that the Taxpayer add back the income
that it paid to the related member for the trademark licenses and denied that any
exception to the add back statute applied
• Alabama Supreme Court Affirmed
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Significant Cases (Cont’d)
• Beneficial New Jersey, Inc. v. Division of Taxation, N.J. Tax. Docket
No. 009886-2007 (Aug. 31, 2010) (unpublished)
• Taxpayer consumer lending company took loan from its parent (on which the
parent charged interest)
• Tax Court did not apply New Jersey’s add back statute and allowed the Taxpayer
to deduct its interest payments to payment because the Tax Court felt that the
Taxpayer satisfied the “unreasonable” exception to the add back statute
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Significant Cases (Cont’d)
• Wendy’s v. Virginia Dep’t of Taxation, 84 Va. Cir. 398 (2012)
• Taxpayer licensed trademarks from related entity and then sub-licensed the
trademarks to both related and unrelated companies
• Circuit Court did not apply the add back statute and allowed the Taxpayer to
deduct the royalties paid for the license. The court felt that the Taxpayer satisfied
one of the “safe harbors” to the add back statute: the related entity derived at least
one third of its gross revenues from unrelated companies as a result of the
Taxpayer’s pass through to the related entity of the royalties paid to the Taxpayer
by unrelated sub-licensees
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Significant Cases (Cont’d)
• Kimberly-Clark Corp. v. Comm’r of Revenue, 981 N.E.2d 208 (Mass.
App. Ct. 2013)
• Taxpayer made a number of payments to related entities as part of a restructuring
that aimed to centralize operational functions amongst the entity family
• The Appeals Court applied the add back statute, and denied the Taxpayer’s
deductions for such expenses. The court declined to apply the “unreasonable”
exception because there was substantial evidence that the Taxpayer’s principal
purpose for the transactions was tax avoidance
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Significant Cases (Cont’d)
• Morgan Stanley & Co. v. Division of Taxation, N.J. Tax Court Docket
No. 007557-2007 (Oct. 29, 2014)
• Taxpayer made interest payments to a related entity
• The Tax Court allowed the Taxpayer to claim deductions for the interest payments.
The Court declined to apply the add back statute. The Court thought that the
Taxpayer satisfied the “unreasonable” exception because the taxing authority
failed to consider the Taxpayer’s evidence for why it met the exception.
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Constitutional Challenges
• Complete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977)
• Substantial Nexus
• Fair Apportionment
• Discrimination
• Fairly Related
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Constitutional Challenges (Cont’d)
• Nexus
• Disallowance of a deduction is functionally equivalent to taxing income
• Hunt-Wesson Inc. v. Franchise Tax Board, 528 U.S. 458 (2000)
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Constitutional Challenges (Cont’d)
• Fair Apportionment
• Internal Consistency Test
• External Consistency Test
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Constitutional Challenges (Cont’d)
• Discrimination
• Foreign Commerce Clause
• Discrimination between Separate and Combined filing states
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Legislative and Administrative Developments
• Not much legislative or regulatory action so far in 2015, but 2013 and
2014 were interesting in select states
• New York SB 2609D (3/28/2013)
• Existing royalty expense add-back exception substantially modified
• The royalty expense add-back will not be required if:
• The taxpayer can establish by clear and convincing evidence that it meets the new
“subject to tax” exception or the amended “conduit” and “treaty” exceptions, or
• The taxpayer and the Commissioner of Taxation and Finance agree in writing to the
application or use of alternative adjustments or computations
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Legislative and Administrative Developments
• Pennsylvania HB 465 (7/9/2013)
• Creates intangible and interest add-back
• Exceptions available: (1) subject to tax; (2) business purpose; (3) treaty; (4)
conduit
• Effective 1/1/2015
• Virginia Document No. 13-140
• Franchise fees characterized as management fees were not subject to addback
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Legislative and Administrative Developments
• Virginia Document No. 13-195 (10/23/2013)
• Ruled that selling receivables to a bankruptcy-remote special purpose entity in
order to obtain financing qualified for the valid business purpose exception from
the add-back statute
• Virginia Document No. 13-211 (11/12/2013)
• Ruled that a single-member limited liability company treated as a disregarded
entity for federal income tax purposes that seeks to exclude the add-back of
factoring fees on the basis that they were incurred for a valid business purpose
must file a state income tax return reporting the addition and petition for a refund
on an amended return
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Legislative and Administrative Developments
• Virginia Document No. 13-239 (12/19/2013)
• Denied a franchise operation company's request to amend corporate tax returns
to exempt royalties paid to a related party from the add-back requirement because
the licensing agreement between the taxpayer and the related party and the
agreements between the taxpayer and its franchisees were substantially different
• Virginia SB 5001 (4/1/2014)
• Subject to tax exception is computed on a post-apportionment basis (state issuing
rulings against taxpayers, see VA Document No. 14-71)
• To claim unrelated transaction exception, related party must actually engage in
transactions with unrelated third-parties
• Retroactive to 1/1/2014
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Legislative and Administrative Developments
• Virginia Document No. 14-60 (4/30/2014)
• Upheld apportionment adjustment to taxpayer’s “subject to tax” add-back
exception, but denied adjustment for portion of fees paid for management services
• Virginia Document No. 14-71 (5/27/2014)
• Upheld apportionment adjustment to taxpayer’s “subject to tax” add-back
exception
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Practical Tips
• Variations, inconsistencies, and multiple taxation
• Watch out for the switcheroo
• Filing requirements
• To add-back or not to add-back
• Add-back exceptions, common challenges and building an audit
ready file
• Dealing with embedded royalties
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Questions?
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