leveraging addbacks of related-party royalties, interest...

Leveraging Addbacks of Related-Party Royalties,

Interest and Expenses in 2013 Responding to Latest State Laws, Regs and Rulings Affecting Multi-State Companies

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WEDNESDAY, SEPTEMBER 11, 2013

Presenting a live 110-minute teleconference with interactive Q&A

Scott Smith, Of Counsel, Baker Donelson Bearman Caldwell & Berkowitz, Nashville, Tenn.

Maria Todorova, Attorney, Sutherland Asbill & Brennan, Atlanta

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Leveraging Addbacks of Related-Party Royalties, Interest and Expenses in 2013

Sept. 11, 2013

Scott D. Smith, Baker Donelson Bearman Caldwell & Berkowitz

[email protected]

Maria Todorova, Sutherland Asbill & Brennan

[email protected]

mailto:[email protected]

Today’s Program

Report on Recent State Addback Laws

[Maria Todorova]

Court Decisions of Note

[Scott Smith and Maria Todorova]

State Agency Rulings and Administrative Guidance of Note

[Scott Smith]

Embedded or indirect intangibles

[Scott Smith]

Embedded or indirect intangibles

[Scott Smith]

Slide 7 - Slide 15

Slide 16 – Slide 24




REPORT ON RECENT STATE ADDBACK LAWS


©2013 Sutherland Asbill & Brennan LLP

Recent Addback Legislation

• New York

S.2609D/A.3009D, effective January 1, 2013

Repeal of the New York State and City royalty income

exclusions

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

8


Recent Addback Legislation (cont’d)

• New York (cont’d)

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

9


• Pennsylvania

House Bill 465, Effective for tax years beginning after

December 31, 2014

Corporate net income tax addback for: (1) intangible

expenses; and (2) interest expenses related to an intangible

that are paid, accrued or incurred directly or indirectly in

connection with one or more transactions with an affiliated

entity

Exceptions: (1) subject to tax; (2) business purpose; (3)

treaty; (4) conduit.


10



• Tennessee

Eff. For tax years ending on or after July 1, 2012

Definition of “intangible expenses” expanded to include “interest

expenses directly or indirectly allowed as deductions or costs in

determining federal taxable income on a separate entity basis

to the extent such interest expenses are … in connection with

the direct or indirect acquisition, use, maintenance,

management, ownership, sale, exchange, license, or any other

disposition of intangible property.” Tenn. Code Ann. § 67-4-

2004(23).

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• Tennessee (cont’d)

Procedure for deducting intangible expenses amended substantially.

The commissioner is required to approve the deduction of

intangible expenses when:

(1) paid to an affiliate in a foreign nation that is a signatory to a

comprehensive income tax treaty with the United States;

(2) to an affiliate when the affiliate, during the same taxable year, has

directly or indirectly paid, accrued or incurred the intangible expense

to an entity that is not an affiliate; and

(3) to an affiliate doing business in, or deriving income from, a state

that imposes a tax on or measured by net income and, under the

state’s laws, the affiliate is subject to an income tax in that state.

Tenn. Code Ann. § 67-4-2006(b)(2)(N)(i)(a) through (c).

No application requesting an appoval is needed.

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• Tennessee (cont’d)

For other transactions, a taxpayer is required to apply for the deduction

and the Commissioner must determine that the expense in question

“did not have as its principal purpose the avoidance of” the excise tax.

Application must be submitted at least 60 days prior to the due

date of the return

An approval granted by the Commissioner remains in effect so

long as the taxpayer provides an annual certification that the facts

and circumstances surrounding the transaction remain

substantially the same

The Commissioner may require the taxpayer to reapply at least

every five years

If the deduction is denied but the taxpayer deducts the disallowed

expense, the Commissioner is directed to asses tax, interest and

penalties.

13


• Oregon

H.B. 3069, Effective January 1, 2013

Prospectively repeals legislation passed in 2009 requiring

addback of intangible expenses and costs paid to related

members

Perception that Oregon’s transfer pricing statute is

sufficient to protect against the abuse the original

addback legislation was intended to prevent

Retroactively expands the safe harbor for a related member

that is a foreign corporation not connected with a US trade

or business


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Slide Intentionally Left Blank

COURT DECISIONS OF NOTE

Scott D. Smith, Baker Donelson Bearman Caldwell & Berkowitz and


Recent Significant Court Cases

Kimberly-Clark Corp. v. Comm’r of Revenue, 981 N.E. 2d 208 (Mass. Ct. App., Jan.

6, 2013), review denied, 984 N.E. 2d 296 (Mass., Mar. 1, 2013).

• 2001-2003 taxable years (Mass. add-back statute for 2002 taxable year)

• 2001-2003 Intercompany Interest Expenses – generated from centralized cash

management system

• Debt formalities followed and used AFR as interest rate

• However, notes contained no security, collateral or default provisions

• AFR rejected as an arm’s length rate; various subsidiaries not proven

to be equally credit-worthy

• 2002 Intercompany Royalty Payments – deduction denied under “sham

transaction” doctrine (Sherwin-Williams)

• IHCO had substantial substance (operating company with 1,200

employees)

17

Recent Significant Court Cases (con’t)

• Court of Appeal applied Sherwin-Williams and interpreted the case to

require (1) no circular flow, and (2) third party licensing activity

• Relevance to Add-Back Statute: clear and convincing evidence

standard underlying taxpayer ability to satisfy the “unreasonable”

exception to add-back

― Witnesses: tax department and accounting department

― Internal memorandum (intended “to produce … significant tax

savings”)

• 2003 Intercompany Rebate Payments – reorganization to replace the

intercompany royalty – deduction denied as an “embedded royalty”

• See Below

18

Recent Significant Court Cases (con’t)

• Sysco Corp. v. Comm’r of Revenue, 986 N.E. 2d 895 (Mass. Ct. App., Apr. 30, 2013),

review denied, 990 N.E. 2d 562 (Mass., June 27, 2013)

• 1996-2001 taxable years

• Another in a long line of Massachusetts cases challenging intercompany

interest expense deductions resulting from centralized cash management

systems.

• Question: intent to repay

― Court applied New York Times Sales (1996) and the multi-factor

analysis of true debt v. equity

― Business purpose (of cash management system) and absence of tax

avoidance motive deemed irrelevant

• A taxpayer cannot prove an intent to repay based only on expert and fact

witness testimony

• Internal financial and accounting descriptions as “loans” are insufficient

• Interest was charged, but no proof that it was paid

19


Royalties & Exceptions

to Addback Statutes

• Wendy’s Int’l, Inc. v. Va. Dep’t of Taxation, No. CL09-

3757 (City of Richmond Circuit Ct. 3/29/2012)

Wendy’s Int’l sought refund of Virginia income taxes for 2004 – 2007

based on exception to intangible expense addback statute

At issue was whether Wendy’s “derived” at least 1/3 of its gross

revenues from the licensing of the intangible property to parties who

are not related members

Virginia Circuit Court of the City of Richmond found that Wendy’s

qualified for the exception to the addback because the license holding

affiliate received 1/3 of its gross revenue from the unrelated

franchisees to whom Wendy’s had sub-licensed intangible property

20


Royalties & Exceptions

to Addback Statutes (cont’d)

• Beneficial New Jersey, Inc. v. Div. of Tax’n, Dkt. No. 009886-2007 (N.J. T.C., Aug. 31, 2010)

Tax Court held that the Division of Taxation’s disallowance, or “add back,” of interest paid by a subsidiary to its parent is “unreasonable;” therefore, the subsidiary’s interest expense deduction was allowed.

Tax Court rejected the taxpayer’s argument that it satisfied the so-called “three percent exception,” agreeing with Div. of Taxation that the 3% range applies to effective rates, not statutory tax rates.

Tax Court also rejected the taxpayer’s argument that the so-called “guarantee exception” applied, narrowly construing the word “guarantee” and holding that the exception did not apply because the subsidiary/taxpayer did not guarantee the parent’s debt.

Tax Court stated that its decision to apply the “unreasonable exception” is not intended to create a rule of general applicability.

The Division of Taxation did not appeal the Tax Court’s decision.

21


Royalties and Exceptions

to Addback Statutes (cont’d)

• States without add-back statutes are attempting to

addback:

Utah has no related member royalty expense add-back

statute

Auditing Division asserted, based on discretionary

adjustment authority, that royalty payments made by

company doing business in Utah to an out-of-state, non-

unitary affiliate must be added back

22


Intercompany Debt & Royalties (cont’d)

• Sysco Corp. v. Comm’r of Revenue, No. 11-P-2108

(Mass. App. Ct. April 30, 2013)

Pre-addback years

Centralized cash management systems with daily sweeps

Manual and bank accounts governed relationship

Interest charged at arm’s-length

Held that there was no intent to repay by applying multifactor

analysis from federal cases and NYT Sales

“Repayment of excess cash advances was neither intended nor

expected”

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AGENCY RULINGS


Agency Rulings

• Indiana – Letter of Findings No. 02-20120310 (July 31, 2013)

• Management company performed management and clerical functions and

was reimbursed on a cost-plus basis and a share of the taxpayer’s profits

• Transfer pricing study determined management fee and profit split using

“residual profit method”

• Department of Revenue allowed deduction for cost-plus, but denied

deduction for residual profit component

• Department relied on the Indiana IRC

482 statute

• Department challenged the transfer pricing study’s calculations (and

stated limitations and rejected the additional “residual profits”

component as a valid deduction

• Department also focused on the post-audit period return of management

fee in form of a deductible dividend (circular flow)

26

Agency Rulings (con’t)

• Tennessee - Letter Ruling # 12-32 (Dec. 19, 2012)

• Accounts receivable factoring transactions are not subject to Tennessee

intangible expense add-back statute

• Accounts receivable do not satisfy definition of “intangible property”

• Other states?

• Update on Tennessee administrative procedures

• Settlement program “ending” September 30, 2013

• Initial review of applications (Form IE-A)

27

Agency Rulings (con’t)

• Virginia – Ruling of Commissioner, P.D. 13-140 (July 19, 2013)

• Audit disallowed deduction for franchise fees paid by taxpayer to parent

corporation

• Amount of royalties eligible for “subject to tax” exception also reduced

to correspond to parent royalty income apportioned to taxing states

• Ruling applied Va. Code

58.1-446 to the franchise fees (general

discretionary authority to disallow deductions)

• Franchise fees “resemble” management fees

• Cost-plus management fee deduction was sustained because parent

corporation had economic substance and supported by multiple

valid transfer pricing study (P.D. 97-132 and P.D. 97-290

distinguished)

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EMBEDDED OR INDIRECT INTANGIBLES


Indirect (“Embedded”) Intangible Expenses

• Intangible expense included (or deemed included) in the cost or price of a

product or service provided to a related party

• Effect: a de facto transfer pricing adjustment

• Common fact patterns: contract manufacturing, limited risk

distributors, sales and marketing, branded goods

• Examples

• Alabama: Ala. Admin. Code r. 810-3-35-.02(3)(d) – Corp B licenses IP

from related Corp C and makes intangible expense payments to Corp C.

Related Corp A purchases products from Corp B on a cost-plus basis.

Corp B’s intangible expenses paid to Corp C are included in the costs of

B’s products sold to Corp A under a cost-plus contract and are “indirect

intangible expenses” of Corp A.

31

Indirect (“Embedded”) Intangible Expenses (con’t)

• Examples (con’t)

• Georgia: Ga. Admin. Rule 560-7-3-.05(3)(b) – Corp A (management

company) licenses IP from and pays an intangible expense to related

Corp B. Corp A’s intangible expense is included in its costs to determine

a management fee paid by related Corp C to Corp A. Corp A’s intangible

expense is an “indirect intangible expense” of Corp C.

• Massachusetts: 830 CMR 63..31.1(3)(a) – “Embedded royalty” means the

“portion of a cost or expense paid, accrued or incurred by a taxpayer for

property received from or services rendered by a related member that

relates to intangible property owned by such related member or to an

intangible expense paid, accrued or incurred by said related member in

a direct or indirect transaction with one or more other related

members.”

32


• Application

• Kimberly-Clark Corp. v. Comm’r of Revenue (Mass. Ct. App. 2013)

• 2003 Rebate Payments: deduction denied as an “embedded

royalty”

• KC replaced intercompany royalties with supply chain management

process (after Mass. enacted the add-back statute)

• Operating subsidiaries remitted the amount of their cost savings

realized from use of patents to a sales company

• The sales company, in turn, remitted the rebates to former IHCO

• Court treated the rebates as payments for “embedded intangibles”

because they were tied to the use of patents

33


• Application – Valid Statutory Interpretation?

• Griffith v. ConAgra Brands, Inc., 728 S.E. 2d 74 (W.Va. 2012)

• Economic presence nexus case, but fact pattern could involve

“embedded intangibles”

• Brands licensed IP to related and unrelated producers of food products

• Producers paid royalties to Brands

• Producers sold foods products bearing Brands’ trademarks to wholesalers

and retailers

• What if the wholesalers/retailers were related parties to Brands and related

producers? Is a portion of their cost to a related producer disallowed?

• What is an “intangible expense” subject to statutory add-back? An expense in

connection, directly or indirectly, with the acquisition, use, disposition, etc.

of “intangible property.”

• What “intangible property” did the wholesale/retailer acquire or use?

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PRACTICAL ISSUES FOR TAXPAYERS WITH INFORMATION-REPORTING



Practical Considerations

• Inconsistent rules may lead to multiple taxation

• Specific filing requirements

• File with addback or without it?

• Common challenges to addback exceptions

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