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
Maria Todorova, Sutherland Asbill & Brennan
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
Slide 25 – Slide 29
Slide 30 – Slide 34
Slide 35 – Slide 36
REPORT ON RECENT STATE ADDBACK LAWS
Maria Todorova, Sutherland Asbill & Brennan
©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
©2013 Sutherland Asbill & Brennan LLP
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
©2013 Sutherland Asbill & Brennan LLP
• 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.
Recent Addback Legislation (cont’d)
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©2013 Sutherland Asbill & Brennan LLP
Recent Addback Legislation (cont’d)
• 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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©2013 Sutherland Asbill & Brennan LLP
Recent Addback Legislation (cont’d)
• 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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©2013 Sutherland Asbill & Brennan LLP
Recent Addback Legislation (cont’d)
• 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.
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©2013 Sutherland Asbill & Brennan LLP
• 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
Recent Addback Legislation (cont’d)
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COURT DECISIONS OF NOTE
Scott D. Smith, Baker Donelson Bearman Caldwell & Berkowitz and
Maria Todorova, Sutherland Asbill & Brennan
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
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©2013 Sutherland Asbill & Brennan LLP
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
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©2013 Sutherland Asbill & Brennan LLP
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
©2013 Sutherland Asbill & Brennan LLP
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
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©2013 Sutherland Asbill & Brennan LLP
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
Scott D. Smith, Baker Donelson Bearman Caldwell & Berkowitz and
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
Scott D. Smith, Baker Donelson Bearman Caldwell & Berkowitz and
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
Indirect (“Embedded”) Intangible Expenses (con’t)
• 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
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Indirect (“Embedded”) Intangible Expenses (con’t)
• 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
Maria Todorova, Sutherland Asbill & Brennan
©2013 Sutherland Asbill & Brennan LLP
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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