The ins and outs of related party add-backs.

Overview

Historically, business performance measurement has relied on various financial measurements. The ability to efficiently manage capital structures and leverage assets is a key indicator of a successful businesses enterprise. Increasingly, to perform these functions effectively, resources must be devoted to identifying key, often hidden, assets and ensuring the financial performance of business units are measured in comparatively meaningful ways.

In today's economy, most companies have created or accumulated through acquisition, a variety of valuable intangible assets. For many companies, these intangibles are the organization's most valuable assets. Other than investment assets, the range of intangibles that a company might own include patents, copyrights, trade names, trademarks, service marks, formulas, processes, proprietary data of various types, and customer lists. At a minimum, maintenance of those intangibles is an increasingly important business function. Identification, valuation, protection, and management of a wide range of intellectual property can be a challenging task.

For a variety of reasons, many companies conduct operations through a number of separate business units. As such, it is common that one unit will use intangibles owned by another related, but separately measured, unit. Effective business unit measurement requires the computation of operating income based upon the value drivers contained within that particular business unit. Therefore, charging the proper arm's-length price for the use of such intangibles is essential to accurate business unit performance measurement as well as effective enterprise-wide management.

Historic Uses of Holding Companies

Holding companies are corporations of a passive nature that typically own passive assets such as investments including the stock of other, often subsidiary, companies. (1) Holding companies have often facilitated the objectives of effective financial and asset management. Segregating functions and assets into discrete legal entities can provide businesses with various benefits, including a functional focus, enhanced liability protection, access to state courts in the jurisdiction of domicile, compliance with regulatory requirements, and the efficient acquisition or disposition of assets. It is the ability of holding company structures to facilitate state tax planning, however, that has made them the focus of intense scrutiny.

Finance Companies

Where a parent company holds debt from its subsidiaries, savings may be realized by the use of a corporate financing company. The subsidiaries continue to deduct the interest payments, but the subsidiary notes held by the parent are transferred to a finance company that has an effective state tax rate that is lower than the parent, reducing the associated tax liabilities. (2)

In addition, a finance company structure can be used to consolidate external debt of subsidiaries that might be subject to different rates of interest. For example, one subsidiary might be paying six percent on its external debt, while another is paying eight percent. Such circumstances make it difficult to compare financial results between operating subsidiaries. The use of a single, centralized, finance company can alleviate these business concerns and, as with subsidiary notes held by the parent, reduce the overall tax liability of the group where the finance company's effective state tax rate is lower than that of the various operating subsidiaries. (3)

Internal leverage, without the use of a designated finance company, can be created by distributing as dividends cash or notes payable. (4) Such dividends will typically qualify for a dividends-received deduction within a federal affiliated group and will also often qualify for a dividends-received deduction at the state level. (5)

Royalty Companies

Historically, companies often placed intangibles into tax-favored special purpose entities operating solely in jurisdictions that have favorable tax rules regarding the taxation of royalty income. Often states having no corporate income tax (for example, Nevada) or states having special holding company regimes (for example, Delaware) were utilized. (6) Alternatively, placing intangibles in entities having a reporting requirement only in combined reporting states provided an income shift from related entities operating in separate entity reporting states.

Often stated business purposes for segregating valuable intangibles from other operating assets included:

* To better protect the intellectual property;

* To facilitate tax efficient acquisitions and dispositions;

* To better manage, and thereby maximize the value of the intellectual property;

* To facilitate third-party licensing of the property;

* To facilitate borrowing and asset securitization; and

* To avail the holding company of favorable corporate and state intellectual property laws.

Attacks on Related Party Transactions

States have long been concerned about efforts by corporate taxpayers to use certain related party charges to manage their state tax liabilities. (7) Attempts by state taxing authorities to combat these types of transactions have evolved in the past ten years. From the perspective of state taxing authorities, the simple fix is arguably to adopt a mandatory combined reporting regime. Lawmakers in separate entity reporting states worry, however, that such a course may actually reduce revenues. (8)

Agency Nexus

Some states have challenged certain tax planning structures by asserting nexus, based on the in-state activities of a related entity. Under such an "agency nexus" theory, the payor of the charges is deemed to be an agent of the payee, thereby creating nexus for the payee in the states in which the payor operates. (9) The agency nexus theory has been difficult for states to advance, in part because contractual licensing does not often equate with common law agency concepts. Licensing and financing transactions typically do not resemble common law principal/agent relationships since neither party can act on behalf of the other nor is there control of one party over the operations of the other. (10)

Forced Combination/Lack of Economic Substance

Separate entity reporting states have also attacked the use of related party transactions through the use of forced combination. The attack is based on the assertion that the related party transaction is distortive of income. (11) Relying on the equitable doctrine of substance over form, (12) states have argued that these arrangements lack both economic substance and business purpose. (13) States argue that, where there is either a lack of economic substance or business purpose and no arm's-length pricing (14) between related unitary (15) entities, the related entities can be forced to file a combined return. (16)

The states, however, have not had a great deal of success in sustaining this argument, typically because most companies use arm's-length pricing to book their intercompany transactions and, traditionally under many state statutes, it is difficult to prove distortion. (17)

Add-Back Legislation

Several separate entity jurisdictions have adopted add-back provisions. (18) These rules generally encompass two broad categories of related party expenses: (1) expenses and interest related to the use of intangibles; and (2) intercompany interest expenses, whether or not such interest is related to the use of an intangible asset.

While some states have had add-back rules in place for several years, the number of jurisdictions adopting such rules has increased dramatically during the last three years. (19) To date, the following jurisdictions have adopted some form of add-back legislation: Alabama, Arkansas, Connecticut, the District of Columbia, Georgia, (20) Illinois, Kentucky, (21) Maryland, Massachusetts, Michigan, Mississippi, New Jersey, New York, North Carolina, Ohio, Oregon, Tennessee, (22) and Virginia.

As with much of state taxation, there are subtle nuances to the application of the add-back rules. Scrutiny of the rules will reveal exceptions beneficial to taxpayers. For example, in New York and North Carolina, add-back is only required for related party royalties and interest expenses related to the use of intangible property; other intercompany interest is not affected. (23) In Alabama and Ohio, the add-back of related party intangible expenses is only required if the related party receiving the payment is primarily engaged in the management of intangible property. (24)

Despite the differences among states, there are several common characteristics of intercompany add-backs. For instance, states generally disallow intangible or interest expense paid to "related members." (25) There are also similarities in the definitions of intangible property and expenses. Intangible property typically includes trademarks, trade names, patents, and copyrights. States broadly define intangible expenses, as well, to capture leveraging, most royalties, and occasionally factoring transactions.

Most states also have a common definition for interest expense. In general, they have adopted the definition contained in section 163 of the Internal Revenue Code. (26) In addition, states often provide limited exceptions or safe harbors for expenses that can vary depending on the type of expense at issue. In order to sustain such deductions, states often require substantiation of business purposes, other than tax avoidance. The forms that state tax agencies develop to implement the add-back legislation should be carefully reviewed, because they sometimes overreach their statutory or judicial mandates. (27)

Payments Subject to Add-Back

There are two broad categories of payments subject to add-back: intangibles and interest. The purchase of intangibles is becoming more common among businesses because of the changing nature of business generally and the creation of an increasing number of related entities. Add-backs, as they relate to intangibles, apply to payments that are made either directly or indirectly to a related member. Within the sales of intangibles, add-backs can apply to a broader set of direct or indirect costs incurred in the transaction. These costs may include the acquisition, sale, exchange, and disposition of the intangibles. The expenses attributable to intercompany intangible movement will be subject to add-back. Additionally, interest on debt incurred to purchase or carry intangibles is also subject to add-back.

The second category of payments subject to add-back is interest. States often apply an add-back to intercompany interest expense whether or not the interest is linked to intangible assets. Some states, however, limit interest expense add-backs to situations where payments are tied to the intangible property of a related member. (28) In some situations, intercompany debt incurred for business purposes may also be subject to add-back.

Exceptions to Add-Backs

There are a number of exceptions to add-backs. These exceptions vary from state to state and can include conduit exceptions, taxability exceptions, treaty exceptions, primary business exceptions, and unreasonable exceptions, among others.

There are several scenarios where intangibles are subject to add-back. These include whether a related member receives income that is subject to income tax in that state, in another state, or in a foreign country--the "taxability" exception. (29) Often states identify "hurdle rates" in order to qualify for the taxability exception. (30)

Another exception to intangible add-back rules is for situations in which a payment is made to a related member in a foreign nation that has a comprehensive tax treaty with the United States. (31) There is frequently a "conduit" exception, available when a related member makes payment to an unrelated entity and tax avoidance is not a principal purpose of the intercompany transaction. There are also exceptions permitting an alternative apportionment methodology if agreed to in writing between the taxpayer and the appropriate tax authority. Finally, there are exceptions if a taxpayer proves by "clear and convincing evidence" that an adjustment is unreasonable.

Similar to the exceptions to add-backs for intangibles, there are exceptions for interest expenses. In effect, the common exceptions to add-back of interest expenses are similar to, but not always identical to, exceptions for royalty expenses.

Chart 1 lists the jurisdictions that have adopted add-back provisions and permit certain common exceptions.

Add-Back Anomalies

As with all general rules, there are anomalies to add-back statutes. Several states treat add-backs differently in certain situations that are worth noting. For instance:

* In Virginia, for any intangible or related interest deduction disallowed by add-back, taxpayers must add back the deduction claimed on their federal return. The taxpayer is permitted, however, to petition the Commissioner of Revenue to review the transaction; the Commissioner is authorized to charge a fee for all direct and indirect costs of reviewing the petition, including the costs of any necessary outside experts. Likewise, no lawsuit may be filed in Virginia courts contesting the action of the Commissioner. (32)

* Massachusetts has a special interest disallowance pertaining to acquisition debt. (33)

* North Carolina provides taxpayers with an option to either combine intangible companies with the related operating company or, as an alternative, to have the intangible holding company file on a stand-alone basis and allocate receipts on market-based sourcing. (34)

* Illinois disallows a deduction for expenses paid to a foreign person who would be a member of the payor's unitary business group but for the foreign person's business activity outside the United States. (35) A "foreign person" for Illinois purposes is defined as any person or entity whose business activity outside the United States is 80 percent or more of their total business activity. (36)

* There is an application of exception on post-apportionment basis in Alabama. (37)

* In Connecticut, there is a three-percent test computed after credits and net operating losses but the statutory rates are computed before credits and net operating losses. (38)

* Connecticut also has an unreasonable exception that can only be claimed if the taxpayer obtains prior written approval from the State. (39)

* The New Jersey foreign treaty exception does not require a three-percent spread and is not conditioned on business purpose. (40)

* New Jersey's Corporation Business Tax form interprets unreasonable exemption to require payment of tax and refund request, contrary to statute. (41)

* There are special exceptions to the add-back rules in Virginia for banks; (42) and in Connecticut, for insurance companies. (43)

Overreaching?

New York Technical Corrections Bill S5725 (October 24, 2003) made significant revisions to the New York City and New York State add-back provisions. Specifically, the Bill repealed the interest add-back provision, other than for debt incurred in connection with royalty/intangible assets. The Bill also amended exceptions to royalty add-backs.

Other states, including Maryland, have contemplated changes to their add-back statutes, fearing that the add-back legislation overreached its legal bounds by penalizing legitimate business transactions.

The Multistate Tax Commission and Add-Backs

On February 25, 2005, the Multistate Tax Commission (MTC) released a model statute addressing related party expense add-back. (44) MTC model statutes often influence state legislation.

The MTC model add-back statute deals with the add-back of interest or intangible expenses payable to a related party. The language of the model statute is very similar to the provisions adopted in a number of states that have currently enacted some form of add-back legislation. (45) The model provisions released by the MTC provide for safe harbors for revenue streams that are taxable in other states or in another country that has a tax treaty with the United States. (46)

Under the model statute, disallowed "intangible expenses" are defined to include, not only expenses, losses, or costs related to the acquisition, use, maintenance or management of intangible property, but also interest related to such intangible expenses and to royalty, patent, technical, copyright, licensing, and similar expenses.

Economic Nexus

Some states have been very aggressive at attacking the physical presence standard for jurisdiction to tax. (47) In Geoffrey, the South Carolina Supreme Court found that the Due Process nexus standard was met by an election to license intangibles in a state, and in doing so, the taxpayer sought to benefit from economic contacts with the state. The court side-stepped the issue of physical presence arguing that, under Quill, physical presence is not necessary to establish nexus for income tax purposes. This reasoning has led to the so-called economic nexus standard which has been embraced by a number of states. (48)

While not having specific related party add-back provisions, many states have asserted such positions on audit. (49) As such, taxpayers are wise to consider a state's position in considering their tax provision reserves related to intercompany charges.

Can You Fight Back?

Some of the states that have enacted add-back provisions have also asserted nexus over passive investment companies (PICs). (50) These states assert that licensing of intangibles or entering into loan agreements with taxpayers in their jurisdiction is a nexus creating activity. (51) The result of this assertion has been mixed. (52)

Furthermore, the assertion of nexus over nonresident PICs raises issues of apportionment. Some states simply source the PICs receipts on a market basis, (53) while other states apportion the income of a company licensing intangibles based on the apportionment percentages of the licensee. (54) These rules run contrary to the general Uniform Division of Income for Tax Purposes Act (UDITPA) sourcing rules based on income-producing activities. Even the application of the UDITPA rule, however, is open to questions depending on whether an income-producing activity is viewed as the sale of goods under the intangible license, or the management, protection, and maintenance of the intangible property.

Unreasonableness

Many states include provisions that an add-back of a given expense is not required if a taxpayer can show that the denial of the deduction is "unreasonable." (55) In some states, the statutes do not require add-back of the relevant expenses if the taxpayer can show by "clear and convincing evidence" that the add-back adjustment is unreasonable. Unfortunately, for taxpayers, the arbiter of reasonableness is often the department of revenue. (56) Some states provide a caveat that the add-back adjustments need not be made if the department of revenue and the taxpayer agree to the use of an alternative apportionment method. (57) Since many of these add-back statutes were created under the watchful eye of lobbyists for commercially domiciled economic interests, taxpayers are well advised to make sure the playing field is level.

Constitutional Issues

Add-back rules may be susceptible to constitutional challenges under the Commerce Clause. (58) In particular, the add-back rules lead one to conclude that a taxpayer will only be allowed a deduction if it organizes its business such that income from its intangibles is subject to taxation. Furthermore, the add-back rules generally force taxpayers to effectively combine profitable entities in separate entity reporting states, while denying taxpayers the privilege of combining non-profitable entities. This elevates taxability over economic practicality.

Collapsing Your PIC

Because of the dwindling perceived benefit of existing PIC structures, some companies may no longer wish to incur the associated compliance and maintenance costs. For those companies thinking of unwinding their existing PICs, potential tax issues should be addressed.

Issues to consider include:

* Recognition of deferred gains. In some circumstances, moving appreciated intangible assets within a consolidated group can create a deferred intercompany gain. (59) If the appreciated asset subsequently leaves the group, such deferred gains would be triggered. (60)

* Supporting business purpose for open years. Many states have asserted that certain PIC structures lack a viable business purpose. For those taxpayers receiving a tax benefit from a PIC for a tax year that is currently open under a statute of limitations, unwinding the PIC structure owing to a lack of state tax benefits tends to undermine any non-tax business purpose that might otherwise be put forward.

* Disposition transactions--stock sale. In situations where companies sell only the stock of a business and such stock is held in a separate corporate entity, a sale of that entity's stock may create allocable nonbusiness income. (61) If the entity selling that stock is, in turn, located in a tax favorable jurisdiction, some or all the potential gain may be shielded from state income tax.

* Disposition transaction--asset sale. In the context of an asset sale, many jurisdictions source the receipts from the sale of intangible assets to the commercial domicile of the entity selling the assets. (62) As such, maintaining intangible assets in entities having their commercial domicile in a favorable tax jurisdiction can be a considerable benefit.

Tax Planning Take Aways for Add-Backs

There are several considerations in dealing with add-back legislation among the states that companies should examine. The following list provides some suggestions for issues to consider when addressing add-backs:

* Closely review safe harbors to determine application to the taxpayer's specific situation; related party transactions are not dead, just more scrutinized.

* Be aware that slight changes in tax rates may affect a company's eligibility for add-back safe harbors.

* Contemporaneously document that any safe harbor applies, particularly the conduit safe harbor.

* In the current environment, be sure to document economic substance and business purpose of passive investment companies.

* Consider the use of certain foreign affiliates in treaty countries.

* Remember to consider possible settlement options with states.

* Examine potential refund opportunities that may arise because of zealousness in complying with the add-back rules, such as double counting income.

Chart 1
General Exceptions

                Minimum Tax          Foreign             Active   Alt
Jurisdiction   Rate Exception        Treaty    Conduit   Member   Appt.

AL                                                         []      []
AR                                                         []      []
CT             Eff. rate = CT          []         []               []
               stat. rate--3%
DC             Stat. rate = 4.5%       []         []               []
GA                                     []         []               []
KY                                     []         []               []
IL                                                []
MD             Agg. eff. rate = 4%                []
MA             Agg. eff rate =         []         []               []
               MA stat. rate--3%
MS                                                []       []
NJ             Eff. rate = NJ          []         []               []
               eff. rate--3%
NY             Eff. rate =                        []
               NY rate
NC                                                []
OH                                                []       []      []
OR
TN                              Disclosure Only
VA                                                []

States with
Related Party Add-Back Rules
As of May 2005

Separate
Entity          Add-Back                        Types of Expenses
State           Legislation   Effective Date       Disallowed

Alabama             X         Years beginning   Interest and
                              after December    intangibles expense.
                              31, 2000

Arkansas            X         Years beginning   Interest and
                              on or after       intangibles expense.
                              January 1, 2004

Connecticut         X         Years beginning   Intangible expense and
                              on or after       interest related to
                              January 1,        intangible expense and
                              1999, for         interest  expense.
                              intangibles and
                              interest
                              related to
                              intangibles.
                              Related party
                              interest add-
                              back effective
                              for tax years
                              beginning on or
                              after January
                              1, 2003.

District of         X         Years ending on   Intangible expense and
Columbia                      or after August   interest related to the
                              2, 2004           use of intangibles.
                              (pending
                              Congressional
                              approval of the
                              District's
                              "Corporate
                              Income Tax Base
                              Protection Act
                              of 2004").

Georgia             X         Years beginning   Intangible expenses and
                              on or after       interest related to the
                              January 1,        use of intangibles.
                              2006.

Kentucky            X         Years beginning   Intangible expenses and
                              on or after       interest related
                              January 1,        to the use of
                              2005.             intangibles and
                                                management fees.

Massachusetts       X         Years beginning   Intangible expense and
                              on or after       interest related to
                              January 1,        intangible expense and
                              2002.             interest expense.

Maryland            X         Years beginning   Interest and
                              after December    intangibles expense.
                              31, 2003.

Michigan            X         For years 1975    Royalties.
                              and after.

Mississippi         X         Years beginning   Intangible expenses and
                              on or after       interest expenses
                              January 1,        related tothe use of
                              2003.             intangibles.

North               X         Effective for     Royalty expenses.
Carolina                      years ending on
                              or after August
                              14, 2003.

New Jersey          X         Years beginning   Interest and
                              on or after       intangibles expense.
                              January 1,
                              2002.

New York            X         Years beginning   Intangible expenses and
                              on or after       interest expenses
                              January 1,        related to the use of
                              2003.             intangibles.

Ohio                X         Years 1999 and    Interest and
                              after.            intangibles expense.

Tennessee       Disclosure    Years beginning   Intangible expenses.
                              on or after
                              January 1,
                              2004.

Virginia            X         Years beginning   Interest and
                              on or after       intangibles expense.
                              January 1,
                              2004.
Unitary
States

Illinois            X         For years         Interest and
                              ending on or      intangibles expense to
                              after December    related 80/20
                              31, 2004.         companies.

Oregon              X         Effective         Royalty expenses.
                              December 31,
                              2003.

Separate
Entity
State           Cite

Alabama         Ala. Code Sec. 40-18-35(b).

Arkansas        Ark. Code Ann. Sec. 26-51-423 (g)(1)

Connecticut     Conn. Gen. Stat. Sec. 12-218(c) 2003
                Conn. Pub. Acts 6, Sec 78.

District of     Corporate Income Tax Base
Columbia        Protection Emergency Act of 2004
                (D.C. Acts of Council 15-486) and
                Corporate Income Tax Base
                Protection Act of 2004 (D.C. Acts of
                Council 15-487).

Georgia         Sec. 48-7-28.3

Kentucky        KRS Sec. 141.205

Massachusetts   Mass. Gen. Laws ch. 63. sec 31-31J.

Maryland        Md. Code Ann, Tax-General Sec. 10-306.1

Michigan        MCL Sec. 208.9

Mississippi     Miss. Code Ann. Sec. 27-7-17.

North           N.C. Gen. Stat. Sec. 105-130.7A
Carolina

New Jersey      N.J. Stat. Ann. Sec. 54:10A-4(k)(2)(l)
                and Sec. 54:10A-4.4.

New York        N.Y. Tax Law Sec. 208(9)(o).

Ohio            Ohio Rev. Code Sec. 5733.042.

Tennessee       H.B. 3438, enacted June 7, 2004

Virginia        Va. Code Ann. Sec. 58.1-402

Unitary
States

Illinois        35 ILCS 5/203(a)(2)(D-17).

Oregon          Ore. Admin Code Sec.150-314-295.

Separate
Entity
State           Things to Note

Alabama         Requires the add-back of direct and indirect
                intangible expenses unless the taxpayer can show the
                income was subject to tax in the same year. No
                adjustments are required if the taxpayer establishes
                they are unreasonable or if the taxpayer can establish
                the transaction did not have a principal purpose of
                avoiding Alabama tax. There is a rebuttable
                presumption that a transaction did not have a tax
                avoidance motive if the transaction is supported by a
                "substantial business purpose and economic substance"
                and contains arm's-length terms and conditions.

Arkansas        The add-back is required unless the income is subject
                to Arkansas tax, another state's tax, or tax in a
                foreign country that has a comprehensive tax treaty
                with the United States or the transaction was made at
                term's arm's length and was not done to avoid Arkansas
                tax, or the taxpayer and the Director of the Department
                of revenue enter into a written agreement prior
                to the due date of the taxpayer's tax return, or the
                taxpayer in a "non-tax" jurisdiction, operates an
                active business there and has at least 50
                full-time-equivalent employees, owns property in that
                jurisdiction with a FMV in excess of $1 million and
                revenue from sources in the non-tax jurisdiction in
                excess of $1 million.

Connecticut     The add-back of the intangible expense (and related
                interest expense) is not required if the taxpayer can
                demonstrate such an add-back is unreasonable or if the
                taxpayer and Connecticut agree to an alternative
                apportionment method. The add-back or intangible
                expenses will not apply if the taxpayer can establish
                the transaction did not have as a principal purpose
                the avoidance of Connecticut tax. The add-back will
                also not apply if the tax due to the add-back could
                have otherwise been avoided by filing a combined
                return in Connecticut. In general, the interest
                add-back will not apply if the taxpayers can show:
                (1) the principal purpose of the transaction was
                not to avoid Connecticut taxes, (2) the charge was made
                at an arm's-length rate and terms; and (3) the interest
                income was subject to tax in Connecticut another state
                or a foreign country.

District of     The new legislation provides for certain exceptions to
Columbia        the required add-back rules. Specifically, the
                disallowance will not apply to the extent they satisfy
                the following conditions: (1) The related member,
                during the same taxable year, incurred the amount to
                or from a person or entity that is not a related
                member, and the transaction was done for a valid
                business purpose; (2) the related member receiving
                the payment acquired the intangible assets from a
                person or entity that was not a related member, the
                transaction was done for valid business purposes, and
                the royalty payments made were made at arm's length;
                (3) the royalty payments are paid or incurred to a
                related member that is organized in a country with
                which the United States has a comprehensive income
                tax treaty; or (4) the related member receiving the
                royalty payments is subject to an income tax, or a
                receipts tax, in a state or U.S. possession at a
                statutory rate of at least 4.5% as long as the related
                member receiving the payment is not considered to be
                subject to tax merely by virtue of the related member's
                inclusion in a combined or consolidated return in one
                or more states.

Georgia         Intangible expenses and costs mean expenses, losses,
                and costs directly or indirectly related to or
                incurred in connection with the direct or indirect
                acquisition, use, maintenance, management, ownership,
                sale, excharge, or disposition of intangible property,
                to the extent such amounts are allowed as deductions or
                costs in determining taxable income before net
                operating loss deduction and special deductions for the
                taxable year.

Kentucky        Unlike the new add-back provisions for intangible
                interest expense and management fees, the current
                legislative language does not expressly require
                add-back of intangible expenses. This would appear to
                be a drafting oversight.

Massachusetts   The intangible add-back provision will not apply if
                the taxpayer can show the add-back is unreasonable or
                the taxpayer and the Commissioner agree to an
                alternative apportionment method. Further, the
                provision will not apply to the portion of the expense
                that the taxpayer can show was ultimately paid to an
                unrelated party and the transaction did not have as a
                principal purse the avoidance of tax. The interest
                add-back will not apply to the extent a taxpayer can
                establish that the principal purpose of the transaction
                was not to avoid Massachusetts tax, the interest is
                paid pursuant to a contract that has arm's-length terms
                and conditions, and the recipient is subject to tax in
                Massachusetts, another state, or a foreign country at a
                rate within 3% of Massachusetts's corporate tax rate.

Maryland        Maryland's safe harbors examine how the recipient
                related party is taxed on the payments in question. The
                safe harbor applies if the recipient related party is
                subject to another state's income tax at a rate of at
                least 4% or if the payor and the related party payee of
                interest are both banks.

Michigan        All royalties are required to be added back to the
                federal taxable income, which makes up a portion of the
                SBT base, except: oil and gas royalties that are
                excluded in the depletion deduction calculation under
                the Internal Revenue Code, cable television franchise
                fees described in section 622 of part III of title VI
                of the Communications Act of 1934, 47 U.S.C. [section]
                542; and certain franchise fees.

Mississippi     Mississippi's add-back does not apply if a taxpayer can
                show there is a valid business purpose other than the
                avoidance of taxes and where the related member
                recipient is not primarily engaged in the management
                of intangible property.

North           Add-back or royalties is required unless the taxpayer
Carolina        can show the related member includes the payment on a
                North Carolina return or the related member pays the
                amount to an unrelated third party.

New Jersey      An interest deduction is permitted to the extent that:
                (1) the principal purpose of the transaction was not
                to avoid New Jersey tax; (2) the interest paid is arm's
                length, and (3) the recipient is subject to income or
                receipts tax in New Jersey, another state, or a
                foreign country at a rate within 3% of New Jersey's
                corporate rate. An interest deduction is also allowed
                if the taxpayer can show the disallowance is
                unreasonable,  or if the taxpayer and New Jersey agree
                to an alternative method of apportionment. Intangible
                deductions are allowed to the extent that the taxpayer
                can show that: (1) the expense is paid to a related
                member in a foreign country with a comprehensive tax
                treaty with the United States; (2) the taxpayer
                establishes the charges are reasonable; or (3) the
                taxpayer and the Director agree to an alternative method
                of apportionment. In addition, the add-back provisions
                do not apply to the extent the payment is directly or
                indirectly made to a third party and the payments were
                not made with the principal purpose of avoiding
                New Jersey taxes.

New York        The New York rules cover royalty payments directly
                connected with the acquisition, use, maintenance,
                management, ownership, sale, or exchange of enumerated
                intangibles and includes interest deduction to the
                existent such amounts are directly or indirectly related
                to the use of intangible assets.

Ohio            The add-back rules apply to expenses directly or
                indirectly paid to certain related members. The rules
                do not apply to "unreasonable" adjustments or if the
                Commissioner and the taxpayer agree to alternative
                adjustment or computations. Further, the add-back
                provisions do not apply if the expenses are directly
                or indirectly paid to a non-related member and the
                transaction giving rise to such expenses does not have
                as principal purpose the avoidance of Ohio corporate
                tax.

Tennessee       This legislation requires Tennessee taxpayers to
                disclose intangible expenses paid to an affiliated
                business and deducted on their Tennessee return. This
                legislation applies to Tennessee returns for tax years
                beginning on or after January 1, 2004. Failure to
                disclose such payments will result in a negligence
                penalty and an add-back, or effective denial, of the
                deduction.

Virginia        Taxpayers can deduct intercompany interest if the
                recipient has substantial business operations in which
                the recipient pays the expense for at least five
                full-time employees who maintain, manage, defend, or
                are otherwise responsible for the operations or
                administration of the interest-generating activities.
                Royalties can be deducted if the recipient derives at
                least one-third of its gross revenues from the
                licensing of tangible property to parties who are not
                related members and the transaction was made at rates
                at which the taxpayers would have entered into such
                transactions with third parties.

Unitary
States

Illinois        The law requires an add-back of amounts otherwise
                allowed as a deduction in computing base income for
                interest paid, accrued, or incurred, directly or
                indirectly to a company that would be a member of the
                unitary group except for the fact that it is an 80/20
                company; the add-back does not apply to interest that
                is paid to an 80/20 company that is subject to an
                income tax in a foreign country or state, other
                than a state that requires mandatory unitary reporting
                on the interest; or the taxpayer can establish (a) that
                the interest was paid to an unrelated member of the
                group and the transaction generating the interest was
                at arm's length, or (b) on clear and convincing
                evidence, that the interest paid was pursuant to an
                arm's-length contract or agreement and the principal
                purpose of the payment is not for tax avoidance, or the
                adjustments are unreasonable or if the taxpayer and
                Director agree to use section 304(f). The bill also
                requires an add-back of certain intangible expenses paid
                to an 80/20 that are otherwise allowed as a deduction.
                The same safe harbor provisions explained above with
                respect to the add-back for interest paid and accrued
                are also adopted with respect to this add-back.

Oregon          The add-back requirement is triggered where both the
                owner and user of the intangible asset are owned by the
                same interests.

(1) Holding companies that hold only the stock of lower-tiered subsidiaries are often referred to as "pure holding companies." Holding companies that manage assets earning passive income are commonly called "passive investment companies" or PICs.

(2) This is typically accomplished by locating ("situsing") the finance company in a tax favorable jurisdiction.

(3) Through this structure, savings can be achieved either by marking up the external debt or charging a service fee for the activities of the finance company.

(4) This strategy is often employed by companies having a significant presence in a combined (unitary) reporting state. For state income tax reporting purposes, the intercompany interest payment would be eliminated for unitary reporting while creating an interest deduction for those entities with filing requirements in separate entity reporting states. Leveraging strategies require the use of arm's-length interest rates, formalization of intercompany notes and amortization schedules, and adherence to commercially reasonable debt-to-equity ratios in order to be sustainable.

(5) Dividend treatment is predicated on the presence of sufficient earnings and profits in the distributing entity. Not all states, however, allow a 100-percent dividends-received deduction for out-of-state corporations. See, e.g., Del. Code Ann. Tit. 30. [section] 1903(a) and N.C. Gem Stat. [section] 105-130.2(5c).

(6) A company electing Holding Company status and limiting its activities to the management of certain intangible assets is exempt from Delaware corporate income tax. Del. Code Ann. Tit. 30, [section] 1902(b)(8).

(7) Related party groups typically make use of intercompany charges as a normal part of day-to-day operations including charges for sales of services and goods between members. The related party charges that are the subject of scrutiny by state taxing authorities are those primarily used to "artificially" shift income between jurisdictions. Typically, the charges receiving the most scrutiny are intercompany royalties, interest, factoring, and management fees.

(8) One scenario in which revenues might be lost is where a profitable separate-entity reporting taxpayer would be able, in a combined reporting context, to reduce its taxable income in a given state by including losses from related entities not operating in the state. In an exception to this trend, Vermont has adopted combined reporting, effective for tax years beginning on or after January 1, 2006, for a taxable corporation that is a member of an affiliated group and is engaged in a unitary business with one or more members of the group. Other states, such as Pennsylvania, have recently considered adopting combined reporting as part of an attempt to reform corporate income tax reporting. (Pennsylvania Governor Edward G. Rendell (D) submitted a proposed 2005-2006 Budget that incorporated many of the proposals recommended by the Pennsylvania Business Tax Reform Commission, including a recommendation that members of a unitary group of businesses be required to file a combined return.) In Massachusetts, S. 1704 would require the members of a unitary business that are subject to taxation in Massachusetts to file a combined report. In Connecticut, proposed H.B. 6972 (introduced on March 22, 2005), would also require combined reporting in certain circumstances.

(9) See, e.g., Kmart Properties, Inc. v. Taxation and Revenue Department of New Mexico, No. 21, 140 (New Mexico Ct. App., Nov. 27, 2001), holding that employees of the operating company were "instrumental" in maintaining and improving the intangible assets owned by a related entity, Kmart Properties, Inc.

(10) See, e.g., Klee, et al. v. United States, 53 F.2d 58, 61 (9th Cir. 1931).

(11) See, e.g., N.Y. Tax Law [subsection] 211.4 and 211.5.

(12) Substance over form is an equitable and tax law doctrine that holds that the substance of a transaction will prevail over its form.

(13) Economic substance addresses whether a given transaction created non-tax monetary benefit for the taxpayer (i.e., reducing the cost of doing business). Business purpose addresses whether there exists any non-tax business purpose for the transaction (such as liability protection, managerial efficiencies, or regulatory compliance).

(14) Arm's-length pricing is usually determined under principle consistent with Internal Revenue Code (I.R.C.) [section] 482.

(15) A "unitary business" is one in which the component parts are so closely connected and necessary to each other that it would be improper to give them separate consideration or to treat them as independent units.

(16) For example, the New York statute presumes a presumption that distortion exists when members of a unitary group engage in substantial intercompany transactions. See N.Y. Tax Law [section] 211.4. This presumption can be rebutted by the taxpayer by showing that the transactions were conducted on an arm's-length basis.

(17) See, e.g., In re Express, Inc., DTA Nos. 812330-612332 & 612334 (N.Y. Div of Tax Appeals, Sept 14, 1995).

(18) Two unitary reporting states also have some form of add-back rules. In July 2004, Illinois passed legislation requiring the add-back of certain interest and intangible expenses paid to an 80/20 company. In addition, Oregon, by regulation, disallows certain intercompany transactions involving intangible assets. OAR [section] 150-314.295.

(19) Ohio has required corporate taxpayers to add-back certain related party expenses since 1999. Michigan has excluded royalty expense from the computation of the SBT base since 1975.

(20) The Georgia legislation requires, for taxable years beginning on or after January 1, 2006, the add-back of related party interest expenses, intangible expenses and costs where the transactions that give rise to the expenses and costs fail to meet specified safe harbors.

(21) In addition to including intangible expenses and interest associated with intangible expanses, Kentucky's new legislation also includes management fees. Furthermore, the text of the legislation does not expressly require add-back of intangible expenses and does not address related exceptions, though it appears that this is a drafting oversight.

(22) Tennessee requires disclosure of certain related party charges, but failure to disclose can result in a denial of the deduction. H.B. 3438, enacted June 7, 2004.

(23) N.Y. Tax Law [section] 208(9)(o)(1)(C) and N.C. Gen. Stat. [section] 105-130.7A(c).

(24) Ala. Code [section] 40-18-35(b)(3) and Ohio Rev. Code Ann. [section] 5733.042(C).

(25) The concept of a "related member" for tax purposes is defined broadly. Generally, I.R.C. [section] 318's attribution rules apply. The ownership percentage for "related member" status is typically 50 percent, but some states have lower thresholds, such as New York with 30 percent.

(26) I.R.C. [section] 163(j)(6)(B) ("The term 'net interest expense' means the excess (if any) of--(i) the interest paid or accrued by the taxpayer during the taxable year, over (ii) the amount of interest includible in the gross income of such taxpayer for such taxable year.").

(27) For example, Connecticut Form 1120AB (Part III, Question 3) requires disclosures not specified within the statutes. In addition, New Jersey has a presumed requirement of prepayment prior to obtaining an "unreasonable" exemption. New Jersey Corporation Business Tax Schedule G-2.

(28) Examples of states where payments are tied to intangible property include Mississippi, New York, and Virginia.

(29) Often, the inclusion of the related party recipient of the payment in a unitary or consolidated return will not qualify the taxpayer for the "taxability" exception.

(30) Many state add-back statutes establish a "hurdle rate" in order to qualify for the taxability exception. Often, the hurdle rates are stated as an aggregate effective rate of at least three percent (e.g., Connecticut, the District of Columbia, Maryland, and New Jersey).

(31) In many cases, the drafters of the statutes seemed concerned with Foreign Commerce Clause limitations on states' ability to apply these rules to foreign owned entities covered by a U.S. tax treaty. Specifically, jurisprudence under the Foreign Commerce Clause requires that state taxes not create a substantial risk of multiple taxation or prevent the federal government from speaking with "one voice" in commercial relations with foreign governments. See, Barclays Bank PLC v. Cal. Franchise Tax Board, 512 U.S. 298 (1994): Japan Line, Ltd. v. County of Los Angeles, 441 U.S. 434 (1979).

(32) The limitation on access to state courts on this issue may facilitate an easier route to obtain federal judicial review as to the Constitutionality of these rules. VA. Code [section] 58.1-402(B)(8)(b).

(33) See Massachusetts Technical Information Release 03-91 (originally issued September 4, 2003, amended and reissued September 19, 2003) (Part 2: c vii). There is also debt push-down, except where the company routinely capitalized with 1.5:1 debt-equity ratio. Id. (Example 14).

(34) N.C. Gen. Stat. [section] 105-130.7A(c).

(35) 35 ILCS 5/203(b)(2).

(36) 35 ILCS 5/203(b)(2)(IV).

(37) Ala. Code [section] 40-18-35(b)(1).

(38) Connecticut Special Notice 2003(22).

(39) Id.

(40) N.J. Rev. Stat. [section] 54:10A-4.4(c)(1).

(41) New Jersey Corporation Business Tax Schedule G-2.

(42) VA. Code [section] 58.1-402(B)(9)(a)(3) and (4).

(43) Connecticut Special Notice 2003(22).

(44) The MTC is an organization that promotes uniform state tax legislation. The organization distributes draft versions of legislation that address a particular issue affecting state taxation. States are not obligated to adopt the uniform legislation, but instead may choose to alter the draft legislation or to not adopt the proposal at all.

(45) For example, the terms "valid business purpose," "related member," and "related entity" are defined under the model statute similarly to the legislation promulgated in Georgia, Kentucky, and Maryland.

(46) See Proposed Model Statute Requiring the Add-back of Certain Intangible and Intangible Expenses: 2-17-05 Draft, http://www.mtc.gov/UNIFORM/add-backstatute.pdf

(47) Quill Corporation v. North Dakota, 504 U.S. 298 (1992). See also Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E. 2d 13, 313 S.C. 15, cert denied, 510 U.S. 992 (November 29, 1993).

(48) States have asserted that various activities constitute "economic nexus," including the licensing of software, the licensing of intangible rights, and the sale or licensing of intangible rights. While the analysis and results differ depending on the nature of the economic transaction in question, at least 37 states assert that at least one of these activities constitutes nexus for purposes of imposing state income tax.

(49) See, e.g., Indiana Department of State Revenue Letters of Finding 00-0379 and 02-0026, citing Gregory v. Helvering, 293 U.S. 4 (1935); Bethlehem Steel Corp. v. Ind. Dept of State Revenue, 597 N.E.2d 1327 (Ind. Tax Ct. 1992); Horn v. Commissioner, 968 F.2d 1229 (D.C. Cir. 1992); Lee v. Commissioner, 155 F.2d 584 (2d Cir. 1998); and Commissioner v. Transp. Trading and Terminal Corp., 176 F.2d 570 (2nd Cir. 1949). See also Cynthia Bridges, Secretary, Department of Revenue, State of Louisiana vs. Autozone Properties, Inc. (La. Mar. 25, 2005).

(50) These include Massachusetts, New Jersey, and North Carolina.

(51) See, e.g., A.F. Trademark, Inc. v. Tolson, No. 02-CVS-7467 (N.C. Super. Ct. May 22, 2003).

(52) See Lanco, Inc. v. Director, Division of Taxation, No. 005329-97 (N.J. Tax Court Oct. 23, 2003).

(53) See N.C. Gen. Stat. [section] 105-130.7A.

(54) E.g., Arkansas DFA Regulation 1996-3.

(55) For example, Alabama, New Jersey, and Ohio.

(56) See N.J. Stat. Ann. [section] 54:10A-4.4(c)(1).

(57) Conn. Gen Stat. Ann. [section] 12-218(c).

(58) U.S. Const. Ann. I, [section] 8, cl. 3.

(59) Gains that might be triggered under I.R.C. [section] 311(b) would be deferred for federal consolidated reporting purposes under Treas. Reg. [section] 1.1502-13. Gains deferred for federal consolidated reporting purposes, however, may not be deferred for state income tax purposes in separate reporting states or in situations where the distributee and distributor entities are not members of the same state reporting group.

(60) Deferred intercompany transaction gains deferred for federal consolidated purposes may be recognized at the time of distribution for separate entity reporting purposes.

(61) Business income is defined as income that arises from transactions and activities in the regular course of a taxpayer's trade or business. Business income includes income from tangible and intangible property if the acquisition, management and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations. Nonbusiness income is defined in the negative, as all income other than business income. UDITPA [subsection] 1(a) and (e).

(62) E.g., D.C. Code [section] 47-1810.02(c)(3).

GILES SUTTON, J.D., LL.M., is an Executive Director of State and Local Taxes with Grant Thornton LLP in the firm s National Tax Office in Washington, D.C.

TODD ZOELLICK, J.D., is an Associate in the firm s State & Local Tax practice in Chicago.