Intercompany transactions can be used to shift income from entities with a physical nexus in many states to a related member with a limited nexus in favorable taxing jurisdictions. In moving to combat the benefits received from such intercompany transactions, states tend to employ one or more of the following concepts: (1) forced combination, (2) economic nexus, (3) expense disallowance, and (4) equitable/discretionary adjustments. This article will focus on interesting developments in some of these areas. Mary Kay Martire and Maria Eberle, two experts on intercompany transactions, supplied the information on which this article is based. Martire is a partner in the Chicago office of McDermott Will & Emory LLP, and Maria Eberle is a partner in the New York office of McDermott Will & Emory.
As this publication goes to press, Martire and Eberle report that at least 25 states and the District of Columbia have laws or regulations requiring combined reporting, at least with respect to related corporations with substantial intercompany transactions.
More troubling, however, because of the lack of certainty, are circumstances in which states see fit to use their equitable powers to force taxpayers to file combined returns. This is particularly true when a discretionary determination also places the burden to disprove the accuracy of a return position, even when the return position is an equitable filing position chosen by the state, on the taxpayer, say the two attorneys.
One relatively recent example of states using this approach is Ind. Dep’t of State Revenue v. Rent-A-Center East Inc., 963 N.E.2d 463 (Indiana 2012). In this decision, the Indiana Department of Revenue (Indiana DOR) forcibly combined Rent-A-Center East with two affiliated entities despite the fact that the affiliates did not operate retail stores in Indiana and had no capital, property, or employees within the state. “The effect of the forced combination was to increase Rent-A-Center’s Indiana state tax liability, for a single year, by more than $513,000,” note Martire and Eberle.
“The effect of the forced combination was to increase Rent-A-Center’s Indiana state tax liability, for a single year, by more than $513,000.”—Mary Kay Martire and Maria Eberle
Not surprisingly, say the two attorneys, Rent-A-Center challenged the Indiana DOR’s combination, and the Indiana Tax Court granted summary judgment for Rent-A-Center based on its conclusion that the Indiana DOR failed to demonstrate that the tax originally paid by Rent-A-Center East did not fairly reflect its Indiana adjusted gross income. (See Ind. Dep’t of State Revenue v. Rent-A-Center East Inc., 952 N.E.2d 387 (Ind. Tax Ct. 2011)). In its opinion overturning the summary judgment ruling, the Indiana Supreme Court held that it was an error to impose this burden on the department. Rather, the court stated, the department’s tax determination itself was sufficient to establish a prima facie case justifying its decision to require forcible combination. Incredibly, the court concluded that it was the taxpayer’s burden “to come forward with sufficient evidence” to show that the department’s decision to combine was an error, according to the two attorneys.
Another topic to watch, say Martire and Eberle, is how states are reacting to the federal codification of the economic substance rule. Some states have taken legislative action by either specifically incorporating Sec. 7701(o)(1) by statute (Cal. Rev. & Tax. Cd. § 19774) or enacting their own economic substance doctrine, which may incorporate federal authorities. See, e.g., Wis. Stat. § 71.10 (2014) and N.C. G.S. 105-130.5A(g) and N.C. Admin. Code 5F.0204. Other states that have not taken legislative action have announced that they will apply the federal common law doctrine of economic substance. States may apply the doctrine on a stand-alone basis (see Sullivan Bros. Inc. v. Wisconsin Dep’t of Revenue, 843 N.W.2d 711 (Wis. Ct. App. 2014)) or as part of other analysis—for example, the state’s distortion rules (Indiana Letter of Finding, No. 10-0383 (11/01/2010)). “Generally speaking, the codification of the federal doctrine has made states more inclined to use economic substance in their analysis of intercompany transactions, even if the state has no specific statutory authority or prior history of common law application of the doctrine,” say the two attorneys.
Virginia’s Add-Back Statute
Another example of a taxpayer-unfriendly challenge to intercompany transactions, say Martire and Eberle, can be found in Virginia’s recent retroactive interpretation of the subject-to-tax exception in its add-back statute. Twenty-three states now have some type of expense disallowance or add-back statute for certain types of payments made between related entities, explain the two attorneys. Add-back statutes typically require a taxpayer, for purposes of computing its net income, to add back to its federal adjusted gross income otherwise-deductible interest expenses and costs and/or intangible expenses and costs directly or indirectly paid to one or more of its related members. (See, e.g., Mass. Gen. L. Ch. 63 § 311(b).)
States provide certain exceptions to the application of their add-back statutes. Several states provide an exception from add-back if the intercompany expense is eventually paid to a third party. See, e.g., Miss. Code Ann. § 27-7-17(2(c)(i). A number of states provide an exception from add-back if the related member is located in a foreign jurisdiction with which the United States has a comprehensive income tax treaty. See, e.g., N.J. Rev. Stat. § 54:10A-4(k)(2)(l). Still others provide an exception where add-back would be “unreasonable.” See, e.g., Ala. Admin. Code 810-3-35-.02(3)(h)(1). Generally, Martire and Eberle say, the conclusion that application of the add-back would be unreasonable hinges on proof of double or unfair taxation. See, e.g., N.J. Admin. Code 18:7-5.18(a)(2) (add-back would be unreasonable if the related party pays tax in New Jersey on the income stream). States may also provide an exception from add-back based on a business purpose analysis. See, e.g., Pa. Stat. Ann. § 7401(3)(1)(t) (add-back is not required for a transaction that did not have as its principal purpose the avoidance of tax due and was done at arm’s-length rate and terms).
The two attorneys note that other states provide for a subject-to-tax exception whereby add-back is required unless the taxpayer can demonstrate that the item of income in question was subject to tax in the state or elsewhere within the United States. See, e.g., Ala. Code § 40-18-35(b)(1). Three states, including, most recently, Virginia, provide that the subject-to-tax exception may only be applied on a post-apportionment basis. The following hypothetical demonstrates the application of this limitation to the subject-to-tax exception:
Corporation A makes a $100 royalty payment to Corporation B, its subsidiary. Corporation B files an income tax return in State X (the only state in which it files a return) and reports the entire $100 payment in its State X net income. Corporation B apportions 5 percent of its income to State X. Despite the subsidiary’s reporting in State X, Corporation A must add back $95 to its income in states with the limited subject-to-tax exception. See, e.g., Ala. Admin. Code 810-3-35-.02(3)(g); N.C. Gen. Stat. § 105-130.7A.
Last year, note Martire and Eberle, Virginia amended its add-back statute (Virginia Code §58.1-402(B)(8)) to add the post-apportionment limitation (HB 5001, signed into law on April 1, 2014). The limitation was made retroactive to taxable years beginning on and after January 1, 2004, presumably on the ground that it conformed Virginia law to previously announced Virginia Tax Commission policy (see, e.g., Tax Commissioner Ruling 14-62 (April 6, 2014), referencing Ruling 07-153 (Oct. 2, 2007)). “It remains to be seen whether the retroactive nature of the Virginia amendment will be subject to constitutional challenge,” state Martire and Eberle.
Finally, in the area of transfer pricing, a recent notable development is the announcement by the Multistate Tax Commission’s (MTC) transfer pricing advisory committee of a preliminary design of a comprehensive, coordinated system for a state government program that addresses transfer pricing issues. If adopted by the MTC’s executive committee, the proposed program, known as Arm’s Length Adjustment Services (ALAS), would kick off in July. The issue is on the committee’s May meeting agenda.
ALAS would assist states by providing a more organized method for addressing both interstate and international income-shifting and the associated loss of state revenues. In its preface to the draft program, the committee states that the program is seeking to “improve business tax compliance in circumstances where taxpayers are found to use transactions among related parties to undermine equity in taxation,” note Martire and Eberle. To the extent it addresses international income-shifting issues, the program is much along the lines of what the United States and foreign governments seek to accomplish in their Base Erosion and Profit Shifting (BEPS) initiative, say the two attorneys. Proponents of the program state that it would encourage opportunities for interstate cooperation on transfer pricing issues, including an information exchange process to support joint work by states on related-party transactions.
Here are the essential elements of the program, according to Martire and Eberle:
- The program would have a substantial training component for states, hiring a tax manager, an attorney with related-party transaction expertise, and a senior economist with substantial transfer pricing experience, all of whom would be charged with the development courses for state tax departments on related-party laws.
- The program would employ a transfer pricing study auditor to both conduct state audits and develop training for state staff to conduct similar audits on a coordinated basis. Taxpayer transfer pricing studies would be subject to a preliminary “technical” audit, in addition to being submitted for an economic analysis.
According to the two tax attorneys, the preliminary design of the program underscores the need for taxpayers to properly document their related-party transactions through transfer pricing studies. “The MTC has announced that the program would begin by reviewing existing taxpayer studies for calculation errors, inconsistencies and flaws in the selection of comparable prices or profits, or other technical problems of a noneconomic nature,” say Martire and Eberle. MTC economists would then be employed to offer expertise on alternative pricing positions.
“It remains to be seen whether the retroactive nature of the Virginia amendment will be subject to constitutional challenge.”
The program would encourage the use of alternative dispute resolution to resolve disputes between states and taxpayers on transfer pricing issues (specifically the MTC alternative dispute resolution process, or ADR). Recognizing, however, that these disputes may not be resolved through ADR, ALAS also would aim to help states win litigation disputes by providing economic expertise to states in cases that proceed to litigation, according to Martire and Eberle.
Michael Levin-Epstein is senior editor of Tax Executive.