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Under the Watchful Eye of State Tax Administrators: The Business-Purpose Doctrine Authors: Editor’s note: Ms. Nakamura is a member of the AICPA Tax Division’s State & Local Taxation Technical Resource Panel. If you would like additional information about this article, contact Ms. Nakamura at karen.m.nakamura@us.pwcglobal.com or Mr. Hogroian at ferdinand.hogroian@us.pwcglobal.com.
Taxpayers have a right to pay no more tax than is legally due. However, given how aggressively some states are applying recent tax law changes, taxpayers need to ensure that their records are adequate to defend against state challenges to payments between related entities and the establishment and operation of special-purpose entities. To do so, taxpayers must have a clear understanding of the business-purpose doctrine.
Background Although taxpayers' arranging their affairs to minimize taxes is a well-settled principle, they are consistently challenged by state taxing authorities when the sole or primary purpose of engaging in a transaction or structuring a business is tax avoidance. In general, such challenges have relied on the business-purpose doctrine and other Federal common-law doctrines in applying tax to a transaction or a discrete entity. In addition, state courts have adopted an analysis of Federal statutory rules (such as Sec. 482) in conjunction with a business-purpose and economic-substance analysis. Some states have also enacted legislation granting revenue departments Sec. 482-type powers, mandating that affiliated members file returns on a consolidated or combined basis or requiring taxpayers to add back otherwise deductible expenses and costs (such as royalty payments made to related parties). Business-purpose doctrine: The origin of the business-purpose doctrine is Federal common law as applicable to tax-free reorganizations. In general, transactions must have a bona fide business (i.e., nontax) purpose apart from Federal income tax avoidance. However, the concept of business purpose does not necessarily mean that a taxpayer's reason for engaging in a transaction has to be free of tax considerations; rather, the transaction must have a business purpose to a bona fide, profit-seeking business. Accordingly, mere compliance with the letter of the tax law is insufficient to support a deduction's validity. Economic-substance doctrine: The economic-substance doctrine is often applied together with the business-purpose doctrine. Rather than looking at a transaction's business purpose, an economic-substance analysis ex-amines whether profit is a possibility and whether the transaction is a mere book entry or entails additional activities. The economic-substance doctrine looks beyond whether a transaction is conducted at arm's length, and instead at the transaction's economic effects. Accordingly, a finding of business purpose is not likely to preclude the application of the economic-substance doctrine. Step-transaction doctrine: Under the step-transaction doctrine, a series of separate transactions are treated as a single transaction, with the aim of recognizing the substance (rather than the form) of the transactions when the separate transactions are in substance integrated, interdependent and focused on a particular result. Inquiries into whether to apply the step-transaction doctrine to collapse a series of "steps" generally include:
Sham-transaction doctrine: The sham-transaction doctrine is typically applied in the context of business purpose and economic substance, and essentially states that a transaction that does not have a valid business purpose and that lacks economic substance may be disregarded. The sham-transaction doctrine examines business purpose, economic substance or both. Phantom-corporation doctrine: As with the sham-transaction doctrine, the phantom-corporation doctrine is typically applied in the context of business purpose and economic substance. Just as the sham-transaction doctrine may be used to disregard a transaction and disallow the tax benefits of that transaction, courts may "pierce the corporate veil" to reach the income-producing entity, defeating the tax benefits of structuring discrete entities. This may focus not only on the discrete entity's business purpose and economic substance, but also on whether the entity has followed the corporate formalities of organizing and running the entity (e.g., appointing officers and holding board meetings).
Federal Tax Principles and the Business-Purpose Doctrine The business-purpose doctrine has been incorporated in the adoption of Sec. 482, under which the IRS has the authority to allocate gross income, deductions, credits or allowances between commonly owned or controlled businesses, when such allocation "is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses." As noted, Sec. 482-type powers have been adopted by some states. The Service can also reallocate income or deductions under Secs. 269 and 446. Under Sec. 269, when a corporation acquires control of another corporation and the acquisition's principal purpose is evasion or avoidance of Federal income tax by securing a deduction, credit or other allowance, the IRS may disallow that deduction, credit or other allowance. Under Sec. 446, when the taxpayer's accounting method does not clearly reflect income, the Service may assign a method that does. This provision is similar to that granted to states under the Uniform Division of Income for Tax Purposes Act, Section 18, which allows a state taxing administrator to use an apportionment method other than the standard method to more clearly reflect income due the state. Regulations under Secs. 6011, 6111(d) and 6112 give the IRS additional power, requiring taxpayers to report potential tax shelters and register confidential corporation tax shelters, and promoters to maintain lists of investors. Recently proposed Federal legislation would codify an economic-substance standard. Proposed HR 5095, the American Competitiveness and Corporate Accountability Act of 2002, would provide that a transaction must change a taxpayer's economic position in a meaningful way (apart from Federal income tax effects), such that the taxpayer has a substantial nontax purpose for entering into the transaction and the transaction is a reasonable means of accomplishing the desired purpose. California is the only state that actively adopted the Federal corporate tax-shelter provisions. Under Cal. Rev. & Tax. Code Section 18628, any person required to register a tax shelter under Sec. 6111 has to send a duplicate of that registration to the Franchise Tax Board (FTB) if it structures the tax shelter in California. In addition, tax-shelter promoters must file an information return with the FTB.
Application to State Tax Planning–IHCs State taxing authorities are applying business-purpose and related doctrines more frequently than before to attack the establishment and operation of special-purpose subsidiaries, such as intangible holding companies (IHCs). States have succeeded in such challenges when a taxpayer's records are insufficient to rebut a state's assertion that the taxpayer's primary purpose for engaging in a transaction or structuring a business is nothing more than mere tax avoidance. Some of the common business purposes taxpayers use in establishing IHCs are to (1) enhance and better manage intangibles, (2) protect intangibles from creditors and hostile takeovers, (3) protect the operating company's officers from trademark disputes, (4) increase the company's operating flexibility, (5) better track the value of the intangibles and (6) act as a profit center for accounting purposes. Whether these ends are met through the establishment of an IHC or whether they are effectuated through a division is key to this analysis. In Syms Corp. v. Mass. Comm'r of Rev., 4/10/02, one of the most recent state court challenges to the establishment and operation of an IHC, the Supreme Judicial Court held that a deduction for royalties paid to a wholly owned subsidiary for trademark use was properly disallowed on the grounds that the royalty agreement was a sham transaction. The agreement lacked economic substance and the royalty was not an ordinary or necessary business expense. The court affirmed a decision of the Appellate Tax Board (ATB) rejecting numerous nontax business purposes proffered by the taxpayer, supporting a deduction of the royalties. The court found that the board properly concluded that although many important business purposes exist for transferring and licensing back intangible assets within a corporate family, the taxpayer's arguments were nothing more than "theoretical musings." Accordingly, the agreement between the taxpayer and its wholly owned subsidiary lacked the necessary economic substance to survive a challenge. In addition, the court found that the ATB properly concluded that the royalty payment was not an ordinary or necessary business expense. The taxpayer did not show that the royalty expense was necessary to the conduct of its business. The court dismissed the taxpayer's assertions that the sole test as to whether a royalty payment is deductible is whether the payment is "arm's length." In The Sherwin-Williams Co. v. Mass. Comm'r of Rev., 7/19/00, a companion case argued before the ATB, the board found that royalty payments from a parent to subsidiaries for the use of trademarks owned by the subsidiaries are not deductible when the parent retains all decision-making authority for the marks and incurs the vast majority of expenses associated with the marks' administration, maintenance and enhancement. The Supreme Judicial Court heard oral arguments in the appeal of Sherwin-Williams about the same time it heard oral arguments in Syms, but has not yet issued a ruling. In finding that the transfer of established trademarks to newly incorporated subsidiaries lacked a business purpose, the ATB reasoned that a wholly owned subsidiary would be powerless to protect the trademarks from the claims of creditors of the subsidiary's parent or from a hostile takeover bidder. In addition, transferring the marks to two different subsidiaries resulted in inefficiencies in managing the marks, creating a diffusion of management and conflicting interests. The assertion that the subsidiaries would facilitate the acquisition of new business conflicted with the stated purpose of protecting the marks. The ATB noted that a transaction with a business purpose might still be disregarded as a sham if it lacks economic substance. The transactions at issue lacked economic substance because Sherwin-Williams' economic position did not change as a result of the transaction. The transactions did not create a risk of loss to Sherwin-Williams; the company retained all benefits and control of the transferred marks. In General Mills Inc. v. Mass. Comm'r of Rev., 6/29/01, the ATB ruled that the Commissioner may require a parent to include in taxable income gains realized on the sale of intangible assets by a subsidiary when the transfer of assets to the subsidiary was done solely to avoid state income tax. Although tax reduction is a legitimate business goal, a business restructure will be disregarded when it lacks a valid business purpose beyond tax avoidance. Citing Sherwin-Williams Co., the ATB found that the taxpayer's goal was to avoid tax by using an intermediary. Consequently, based on the step-transaction doctrine, the transfer of assets to a subsidiary had to be disregarded. Despite the transaction's form, its substance was the parent's direct sale of trademarks.
Other State Income Tax Planning Applications In the Carpenter Technology Corp., 6/27/02, the New York Supreme Court, Appellate Division, upheld a Tax Appeals Tribunal ruling that the Division of Taxation properly disallowed certain interest expense deductions claimed by a corporation, when the corporation computed its entire net income tax base and then added back the interest expense as interest directly attributable to subsidiary capital. In so ruling, the tribunal dismissed assertions that the taxpayer had a legitimate business purpose for forming a wholly owned subsidiary to hold certain assets, including approximately $300 million and an investment in foreign business operations, with the goal of removing itself from direct ownership in such operations. The fact that the debt can be only directly attributed to a bona-fide business purpose was not sufficient to defeat disallowance of the interest deduction. Moreover, it was unclear how the loan from the subsidiary to the parent (as opposed to its initial cash contribution) helped Carpenter insulate itself from the risks associated with its expansion into foreign countries. In Zebra Technologies Corp. v. Illinois Dep't of Rev. (DOR), 7/23/01, the Illinois Circuit Court of Cook County held that services performed in the U.S. by an affiliated entity's employees have to be considered in determining whether 80% or more of a foreign sales corporation's (FSC's) business activities are conducted outside the U.S. In reaching this conclusion, the court found that although the FSC's headquarters was in the Virgin Islands, the office served no valid business purpose. In Overnite Transportation Co. v. Comm'r of Rev., 3/12/02, the Massachusetts Appeals Court held that a note paid as a dividend to a parent was not a valid debt; thus, the payor subsidiary could not de-duct "interest" payments made under the note from its gross income for corporate excise tax purposes. In its ruling, the court stated that although an intercompany debt ar-rangement should not be automatically disqualified as a debt, such self-dealing requires close scrutiny to determine the transaction's "essential nature." To support the validity of intercompany-interest deductions, a taxpayer must show that the (1) business purpose for the intercompany debt is clear, (2) debt is "genuine" and does not impose a "dubious burden" on a payor and (3) debt has some reasonable enforcement mechanism and contains a provision for security.
Successful Taxpayer Defenses: Same Facts, Different Results Several other cases involve facts substantially similar to those discussed already, and have been rejected by courts. Even though the determination of business purpose and economic substance is highly fact-specific, the outcome of similar cases in different jurisdictions often hinges on the respective jurisdictions' tax structure and case law. For example, because New York allows a showing of arm's-length pricing to rebut the presumption of distortion for substantial intercorporate transactions, the New York Division of Tax Appeals relied heavily on a taxpayer's transfer-pricing study. The division also accepted the taxpayer's business-purpose arguments, which, under the same facts, were unpersuasive to the Massachusetts ATB in Sherwin-Williams. Taxpayers can proactively guard against business-purpose and related arguments by considering significant economic and business purposes, as well as conducting an adequate transfer-pricing study, prior to engaging in a transaction. Defenses to state challenges based on Federal common-law doctrines include:
In Carpenter Technology Corp. v. Comm'r of Rev. Services, 6/19/01, the Connecticut Supreme Court held that the interest a corporate taxpayer paid on a loan made to its wholly owned subsidiary was properly deducted, because the subsidiary had economic substance and a business purpose and the relationship and transactions between the two entities were legitimate business arrangements. The state supreme court found that the trial court correctly sustained the taxpayer's appeal of the Connecticut Commissioner of Revenue Services' disallowance of the deductions on the basis that the subsidiary was a sham corporation and that the entities were a single entity for tax purposes. The facts of the case are the same as those considered by the New York Supreme Court in Carpenter Technology Corp. Carpenter Technology formed a subsidiary with a substantial infusion of cash, and the subsidiary loaned back almost all of that money, requiring interest payments at 2% over prime. In allowing Carpenter's interest expense deductions under the lending agreement, the trial court found that the subsidiary was a separate and viable corporation and that Carpenter consistently paid its obligation under the debt agreement. The subsidiary was formed for a legitimate business purpose and properly organized with employees, officers and a board of directors. Also, it paid salaries, taxes, rent and other corporate expenses. Through its initial capital contribution to the subsidiary, Carpenter fulfilled its objective to form a domestic corporation that had economic substance and could withstand creditors' claims. The mere fact that the subsidiary loaned the money it received as a capital contribution back to its parent did not minimize the subsidiary's economic substance. The subsidiary had economic and business purposes and the loan reflected an arm's-length relationship deserving respect. Following Carpenter, the Connecticut governor signed into law HB 6002 (7/1/02), which states that the adjustment at issue in Carpenter was properly the subject of a discretionary adjustment by the Commissioner of Revenue. In addition, the law clarifies that the Commissioner's discretionary authority to adjust income items, deductions and capital may not be exercised arbitrarily, capriciously or unreasonably. In MCI Int'l Telecommunications Corp. v. Maryland Comptroller of the Treasury, 3/17/00, the Circuit Court for Baltimore City affirmed a Maryland Tax Court ruling that an in-state operating company's activities may not be attributed to an out-of-state affiliate when the out-of-state affiliate is not a phantom entity. The court found that the out-of-state affiliate performed activities that generated income, and earned revenues from affiliated and nonaffiliated entities. In addition, the out-of-state affiliate had substantial property on its books and incurred personnel expense through the payment of management fees. Accordingly, the out-of-state affiliate was not a phantom corporation and nexus could not be attributed to it for Maryland taxation purposes. Following on the MCI's heels, the Maryland Tax Court ruled in favor of the taxpayers in two separate rulings on IHCs. In SYL Inc. v. Comptroller of the Treasury, 4/26/99, and Crown Cork and Seal, 4/26/99, the tax court dismissed the comptroller's assertions that the use of intangibles by an in-state affiliate was sufficient to create nexus for an out-of-state company that was not a phantom entity and all of its income-producing activity occured outside of Maryland. Those rulings were upheld by the circuit court. Oral arguments in the appeal of SYL and Crown Cork were heard by the Maryland Court of Appeals in January 2001. Decisions in those matters are still pending. Besides business purpose, another important question is whether demonstrating arm's-length pricing and compliance with Federal law (i.e., transfer-pricing rules) is sufficient to establish that a transaction has economic substance for state tax purposes. In the Matter of the Petition of The Sherwin-Williams Company, 6/7/01, an administrative law judge (ALJ) of the New York Division of Tax Appeals ruled that a corporation may not be required to file its franchise tax report on a combined basis with its IHC subsidiaries when there are valid business purposes for the subsidiary's formation and operation and intercompany transactions are arm's length. The ALJ concluded that the subsidiaries were formed for valid business purposes, including the (1) centralization of the trademarks, (2) ability to address various environmental and legal issues, (3) incorporation in a favorable taxing jurisdiction, (4) license of the trademarks to related and unrelated entities, (5) aversion of a potential hostile takeover, (6) ability to better manage income from the marks and (7) securitization of the subsidiaries' royalty income stream, as an additional source of financing. In addition, the ALJ concluded that the subsidiaries carried out substantial business in their own names, actively managed and protected the trademarks, paid for and filed trademark applications and renewals, pursued potential infringers, entered into license agreements with third parties and invested the royalty income received from the license agreements. It also found that an intercompany pricing report prepared for the taxpayer sufficiently rebutted any presumption of distortion, and that the intercompany transactions were arm's length.
Legislative Developments As noted, state legislatures are increasingly enacting laws specifically requiring a business purpose for "suspect" transactions, granting expanded discretionary powers to state revenue departments and requiring in-state companies to add back certain otherwise deductible expenses. Such addbacks may apply to expenses (including royalties and interest) paid to related members whose activities are limited to the maintenance and management of intangible assets. These addback provisions thus avoid the jurisdictional issues associated with an economic nexus challenge. For example, Alabama enacted legislation in 2001 limiting the deduction for certain intercompany interest and royalty payments and expanding the DOR commissioner's discretionary authority to adjust income reported from related-party transactions. In addition, for all tax years beginning after 2000, HB 2 and HB 4 limit the deduction for expenses, losses and costs for, related to or incurred in connection with the acquisition, use, maintenance, management, ownership, sale, exchange or disposition of intangible property; expenses or losses related to factoring or discounting transactions; and royalties, patents, technical and copyright licensing fees and other similar expenses or costs paid to a related party. The deduction will not be limited if the taxpayer establishes that the transaction's principle purpose is not tax avoidance and the related member is not primarily engaged in the acquisition, use, licensing, maintenance, management, ownership, sale, exchange or disposition of intangible property, or in financing of related entities. A transaction will be deemed not primarily for purposes of avoiding tax if it has a substantial business purpose and economic substance, and contains terms and conditions comparable to similar arm's-length transactions between unrelated parties. Similarly, Mississippi legislation enacted in 2001 grants the Commissioner of Revenue authority to require an addback of otherwise deductible expenses and costs arising from a transaction lacking a valid business purpose. HB 1695 grants the commissioner the authority to consider if a transaction by a corporation or other legal entity could be arm's length, by determining whether the:
When a transaction lacks a valid business purpose, the legislation requires a taxpayer to add back otherwise deductible interest expenses and costs and intangible expenses, and costs paid, accrued or incurred in connection with a transaction with a related member. Intangible expenses and costs include expenses, losses and costs related to factoring and discounting transactions; royalty, patent, technical and copyright fees; and licensing fees and other similar expenses and costs. Intangible property includes patents, patent applications, trade names, trademarks, service marks, copyrights and similar types of intangible assets. The addback does not apply to any portion of expenses and costs paid to a related member not primarily engaged in transactions involving intangible property, provided the transaction has a valid business purpose. Similarly, the addback does not apply to expenses and costs paid to an unrelated entity. In 2001, North Carolina also enacted legislation requiring taxpayers to add back to taxable income royalty payments made to a related member for the in-state use of trademarks. HB 1157 provides that taxpayers must add back to Federal taxable income royalty payments for the use of trademarks in the state that are made to, or in connection with, transactions with a related member during the tax year. An addback is not required when the recipient related member includes the royalty payments in income in the same tax year that the paying member deducts the payments. In addition, paying members are required to add back royalty payments when the recipient related member directly or indirectly paid, accrued or incurred the amount during the same tax year to a nonrelated person. Most recently, New Jersey enacted legislation requiring taxpayers to add back otherwise-deductible interest expenses and costs and intangible expenses and costs directly or indirectly paid, accrued or incurred to, or in connection directly or indirectly with, one or more direct or indirect transactions with one or more related members. Under P.L. 2002, an addback will not be required if the interest expenses and costs and intangible expenses and costs are directly or indirectly paid, accrued or incurred to a related member in a foreign nation that has a comprehensive income tax treaty with the U.S. in force, the taxpayer establishes by clear and convincing evidence (as determined by the Director of the Division of Taxation) that the adjustments are unreasonable, or the taxpayer or Director agree in writing to an alterative apportionment method.
Sales and Use Tax Applications The business-purpose doctrine and related doctrines have not been employed as much in the field of state sales and use taxes, as courts have generally decided to respect a transaction's form rather than employ concepts from income taxation. However, states can introduce Federal common-law doctrines into statutes granting revenue departments discretion in looking behind the transaction's form and taxing its "substance." In 2001, Ohio enacted legislation granting the Tax Commissioner the ability to disregard sham transactions and establish a taxpayer's liability without such transactions. Under HB 405, a "sham transaction" is defined as a lease transaction or series of transactions without economic substance, because no business purpose or expectation of profit exists other than obtaining tax benefits. A lease with a renewal clause and a termination penalty, which applies if the renewal clause is not exercised, would be considered a sham transaction and, as such, the tax would be due on the entire lease term until the termination penalty no longer applies. The legislation also gives Ohio's Tax Commissioner the ability to prescribe rules to administer the section. The West Virginia Supreme Court of Appeals, applying the substance-over-form doctrine, allowed a sales-and-use-tax exemption for services performed between related entities, even though the transaction was a lease of tangible personal property, finding that the transaction's substance was for the provision of services (CB&T Operations Co. v. Tax Comm'r, 2/25/02).
Application to Other Taxes The business-purpose doctrine and related Federal common-law doctrines developed in the context of income taxation. However, this has not precluded the application of the doctrines in other areas. Such application is not limited to sales or use taxes, as any non-income-tax planning strategy that involves special-purpose entities, multiple steps or other such devices commonly questioned under the doctrines may be subject to scrutiny. For example, the California courts have applied the step-transaction doctrine in the context of property taxes.
Conclusion As state revenue departments continue to question planning strategies by employing business-purpose and related Federal common-law doctrines, state courts are also likely to continue to apply these Federal principles. While a transaction's treatment may vary depending on a state's particular tax law, taxpayers should guard against a negative outcome by avoiding the "bad facts" that signal a court to apply these doctrines. Strong facts establishing a legitimate business purpose and economic substance must be present if a planning strategy is to succeed in any state, at least as applied to income/franchise taxes. |
