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Deducting Related-Party Interest and Intangible Expenses Over a dozen states have enacted laws disallowing deductions for interest and intangible expenses paid to related parties, and several other states have proposed such laws. This article provides an overview of various state interest and intangible expense addback provisions.
Michael S. Schadewald, Ph.D., CPA For more information about this article, contact Dr. Schadewald at schade@uwm.edu.
In response to fiscal pressures and the perception that significant tax revenues are being lost to corporate tax shelter activities, states have enacted laws that disallow deductions for interest and intangible expenses paid to related parties. In 2004, Illinois, Maryland, Tennessee, Virginia and the District of Columbia enacted such anti-passive investment company provisions. Similar provisions were enacted in 2003 by Arkansas, Massachusetts, New York (as well as New York City) and Oregon; by New Jersey in 2002; by Alabama, Mississippi and North Carolina in 2001; by Connecticut in 1998; and by Ohio in 1991. In recent years, similar legislation was also introduced in Indiana, Missouri, Pennsylvania, Rhode Island, Texas and West Virginia. By requiring corporations to add back otherwise deductible interest and intangible expenses, states limit corporate taxpayers ability to use intercompany licensing and financing arrangements to reduce state income taxes. This article provides an overview of the various state interest and intangible expense addback provisions. These provisions contain numerous special rules and exceptions; although the various state statutes share common themes, there are significant differences among the states. Thus, a thorough analysis of each states provisions is required to ensure compliance.
Background An example of the type of arrangement targeted by state addback provisions is the use of trademark holding companies. An operating company transfers its trademarks and other marketing intangibles to a separately incorporated subsidiary organized in Delaware (which does not tax the income of intangible property companies)1 or in a state like Nevada (which has no corporate income tax). The subsidiary then licenses the intangibles back to the operating affiliate. This transaction gives the operating company a royalty expense deduction that reduces its state income tax in a separate-company reporting state. In contrast, the corresponding royalty income is tax free, because the payees income is not subject to state income tax. In requiring the operating company to add back the royalty expense deductions, states deny the tax benefit of establishing an intangible property company. Such companies generally do not reduce taxes in states that require combined unitary reporting, because the intercompany income and expenses offset each other when the operating company and the intangible property company are combined. If foreign affiliates are not included in the combination, however, any interest or intangible expenses that the unitary groups U.S. members pay or accrue to an offshore intangible property company might reduce state taxable income.
Expenses Targeted by Addback Provisions The states that disallow deductions for related-party payments generally require a corporation to add back to Federal taxable income, any otherwise deductible intangible and interest expenses directly or indirectly paid or accrued to a related member (see Exhibit 1). All of the state addback provisions apply to intangible expenses (e.g., royalties); most also apply to interest expense. In recognizing that intercompany financing and licensing arrangements are often motivated by valid business purposes and not tax avoidance, each state provides some relief from the automatic disallowance of such deductions, through statutory exceptions.
Interest Expenses In most states, the addback requirement applies to any otherwise deductible interest expense paid or accrued to a related member, unless a statutory exception applies. For ex-ample, Marylands and New Jerseys addback provisions apply to any otherwise deductible interest expense paid or accrued to a related member.2 For this purpose, both states define interest expense as amounts deductible under Internal Revenue Code (IRC) Sec. 163.3 Some states, such as Mississippi and New York, require an addback only of interest expense related to the acquisition, ownership or disposition of intangible assets.4 For example, if a parent pays a royalty to a subsidiary intangible property company, and the subsidiary lends the funds back to the parent, the parents interest paid on the loan must be added back.
Intangible Expenses State addback provisions also generally apply to any otherwise deductible intangible expenses paid or accrued to a related member, unless a statutory exception applies. Although the principal target of these provisions is related-party royalties, the concept of intangible expenses in most states is broader. For example, the Virginia addback provision defines intangible expenses and costs to include (1) otherwise deductible expenses, losses and costs related to the acquisition, ownership or disposition of intangible property; (2) losses related to factoring transactions; (3) royalty, patent, technical and copyright fees; (4) licensing fees; and (5) other similar expenses and costs. For this purpose, intangible property means patents, patent applications, trade names, trademarks, service marks, copyrights and similar types of intangible assets.5 North Carolina has a narrowly drawn addback provision that applies only to deductions for a North Carolina royalty, which is a royalty, technical fee, licensing fee or similar charge for the use in the state of a trademark, trade name, service mark or similar type of intangible asset.6 For example, at the taxpayers election, if a corporation that operates retail stores in North Carolina pays a royalty to a related member for the use of trademarks at its retail locations in the state, the taxpayer must either add back the royalty in computing its North Carolina taxable income, or the related payee must include the royalty income on a North Carolina income tax return filed for the same tax year in which the taxpayer deducts the royalty expense.
Related Members State addback provisions apply to certain expenses paid or accrued to a related member. A related member generally includes, among other things, a component member of a controlled corporate group (as defined in Sec. 1563(b)) of which the taxpayer is a member.7 The control test in IRC Sec. 1563(b) is 80%-or-more stock ownership; thus, members of an affiliated group (as defined in IRC Sec. 1504(a)) that elect to file a Federal consolidated return are generally deemed related for purposes of state addback provisions. State definitions of a related member also generally include a related entity, such as an individual who directly or indirectly owns at least 50% of the value of the taxpayers outstanding stock. New Yorks definition is broader and includes any corporation or other entity, when one such entity (or a set of related entities) owns or controls at least 30% of the combined voting power or at least 30% of the capital, profits or beneficial interests in the other entity.8
When Addback Not Required States that require taxpayers to add back interest and intangible expenses paid or accrued to related members generally offer some relief from the automatic disallowance of such deductions. These exceptions reflect the reality that many intercompany financing and licensing arrangements are motivated by legitimate business purposes, rather than tax avoidance. The exceptions are quite complex and often apply to one type of related-party payment, interest expense or intangible expense, but not the other. The exceptions are summarized below.
Conduit Payment Exception Some states do not require related-party interest or intangible expense addbacks if the taxpayer establishes that (1) the related-income recipient paid the expense to an unrelated person during the same year and (2) tax avoidance was not a principal purpose of the related-party transaction that gave rise to the expense (see Exhibit 2, Column A). This exception reflects the view that the related payee is merely a conduit for the taxpayers payment of legitimate interest or intangible expenses to an unrelated third party. Examples of nontax business purposes for related-party interest payments include centralized borrowing from public capital markets followed by intercompany loans to operating units, and centralized cash management transactions, in which surplus cash generated by some affiliates is pooled and used to pay other affiliates expenses. For New York tax purposes, the conduit exception applies only if the taxpayer also establishes that the related-party payment was arms length, and the transaction had a valid business purpose. A valid business purpose is one or more business purposes, other than the avoidance or reduction of taxation, which alone or in combination constitute the primary motivation for some business activity or transaction, which activity or transaction changes in a meaningful way, apart from tax effects, the economic position of the taxpayer.9 In contrast, for Mississippi and North Carolina tax purposes, the taxpayer need not establish the lack of a tax avoidance motive for the conduit exception to apply.
Taxation of Corresponding Income Exception Some states do not require an addback if the corresponding income is taxed to the related payee, in which case the transaction does not necessarily reduce the related parties combined state tax burden (see Exhibit 2, Column B). For example, under Alabamas provision, no addback is required if the corresponding item of income was in the same taxable year subject to a tax based on or measured by the related members net income in Alabama or any other state of the United States, or by a foreign nation which has in force an income tax treaty with the United States.10 This exception does not apply if the related payees income is offset or eliminated in a combined or consolidated return. In addition, the exception applies only to the extent the corresponding item of income is included in the related payees post-apportionment taxable income. An example is provided by the Alabama Department of Revenue (DOR): A Corp. pays a $100 royalty to B Corp., a related member. B files an income tax return only in State B, to which it apportions 5% of its income. A must add back $95 of the $100 in royalties; the other $5 qualifies for the exception.11 In many states, the subject to tax exception applies only if the related payees corresponding income bears a certain type or level of taxation. For example, the North Carolina exception applies only if the related payee includes the corresponding income in that states return filed for the same tax year. The New York exception applies only to income paid to a corporation organized in a foreign country that has an income tax treaty with the U.S., and is taxed in the foreign country at a rate at least equal to New Yorks. The Connecticut, Massachusetts and New Jersey exceptions apply only to interest (not royalties), and only if the effective (or, in some cases, aggregate) state tax rate on the related payees income is within three percentage points of the states effective (or, in some cases, statutory) tax rate.
Unreasonable Addback Exception A third common exception applies if the addback of related-party expenses produces an unreasonable result (see Exhibit 2, Column C). For example, according to Connecticut law,13 an addback adjustment is not required if the corporation establishes by clear and convincing evidence that the adjustments are unreasonable. For Alabama tax purposes, an adjustment is unreasonable if it has increased the taxpayers Alabama income tax liability to an amount that bears no fair relation to the taxpayers Alabama presence.14 The New Jersey Division of Taxation identifies two potential situations in which adding back interest expense may produce an unreasonable result: (1) interest paid on intercompany payables/receivables created by cash sweeps from some affiliates and paying the expenses of other affiliates, when interest is credited to the entity relinquishing the funds, and each party profits from the transactions; and (2) interest paid on debt incurred to acquire a company, when the debt was pushed down to the acquired company without a guarantee by the taxpayer, and the taxpayer supplies appropriate documentation.15
Alternative Adjustment Exception A fourth common exception provides relief if a taxpayer and state tax authorities agree to an alternative adjustment (see Exhibit 2, Column D). For example, under Massachusetts law,16 an addback is not required if the taxpayer and the commissioner agree in writing to the application or use of an alternative method of apportionment. The New Jersey Division of Taxation will allow an alternative method of apportionment if the taxpayer is taxed upon more than 100% of its income.17 Under Virginia law, the taxpayer must petition the tax commissioner for relief after filing its income tax return for the year and demonstrate by clear and convincing evidence that the related-party transaction had a valid business purpose other than tax avoidance.18
Other Circumstances Exhibit 2, Column E, details other circumstances in which a taxpayer need not add back related-party interest or intangible expenses. For example, Connecticut, Massachusetts and New Jersey all provide exceptions for certain payments to a related member that is a resident of a foreign country having an income tax treaty with the U.S. The details vary from state to state. Ohio provides an exception when the increased tax attributable to the addback would have been avoided had the taxpayer and the related member, to which it paid the expense, filed a combined return. Alabama and Mississippi do not require an addback when the related-party transaction was not tax-motivated, and the related payee is not primarily engaged in activities relating to intangible assets. For Alabama tax purposes, primarily engaged means the related payees receipts from intangibles activities exceed any other category of receipts. For example, if a company derives $400 of receipts from licensing intangibles, and $300 each from selling and repairing widgets, it is primarily engaged in intangibles activities, because its royalties exceed its receipts from either selling goods or rendering services.19 As a final example, Tennessee allows a deduction for related-party intangible expenses if the taxpayer discloses the expenses on its return and completes the schedule required by the commissioner. In addition, any taxpayer that claims a deduction without making the requisite disclosures is subject to a negligence penalty in addition to the tax assessment.20
Combined Reporting States As noted above, intangible property company planning strategies generally do not erode the tax base of a state that requires combined unitary reporting, because the intercompany income and expenses offset one another when the operating and intangible property companies are combined. If foreign country affiliates are not included in the combination, however, any interest or intangible expenses paid or accrued to an offshore intangible property company might reduce state taxable income. For example, for Illinois combined reporting purposes, a unitary business group does not include an otherwise unitary member whose business activity outside the U.S. is 80% or more of the members total business activity21 (generally referred to as 80/20 companies). Effective for tax years ending after Dec. 30, 2004, unitary groups filing an Illinois tax return must add back otherwise deductible interest and intangible expenses paid or accrued to 80/20 companies, subject to numerous ex-ceptions.22 In 2003, the Oregon DOR promulgated a similar regulation to require the addback of related-party intangible expenses in particular circumstances.23 An addback is required if (1) the owner and user of an intangible asset (e.g., a trademark) are owned by the same interests; (2) the owner and user are not included in the same Oregon return; and (3) the separation of the ownership and the use of the intangible asset either (i) has no effect on the users operations other than payment of the royalty (resulting in tax evasion) or (ii) affects Oregon taxable income so that it does not clearly reflect the business activity conducted in the state in comparison to business activity as a whole. The regulation provides an example of a retailer paying royalties for the use of a trademark held by a subsidiary incorporated in Bermuda.
Conclusion Over a dozen states have enacted related-party interest and intangible expenses addback provisions designed to limit corporate ability to use intercompany licensing and financing arrangements to reduce state income taxes. In recent years, other states have introduced similar legislation. Although the various state statutes share common themes, there are significant differences among them, relating mostly to the circumstances under which an exception applies and an addback is not required. As a result, these provisions have significantly increased the compliance burden for multistate corporate taxpayers. |
