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State laws and legislation disallowing certain intercompany expenses.

Editor's note: Ms. Naghavi chairs the AICPA Tax Division's State and Local Tax Technical Resource Panel (TRP). Ms. Boucher is a former chair of that TRIP.

For more information about this column, contact Ms. Boucher at kboucher@deloitte.com.

Over the past several years, a number of states not requiring unitary corporations to use a combined reporting method, have enacted legislation to limit (or eliminate) common state tax planning strategies for paying royalties or interest to affiliated trademark, tradename or finance companies. This article identifies the six states that enacted such laws prior to 2003 and summarizes the 2003 state legislative activity (through June 2003) for limiting such intercompany deductions.

Laws Enacted Prior to 2003

Alabama: For tax years beginning after 2000, corporations must add back to Federal taxable income interest and intangible expenses/costs directly or indirectly paid to a related member, unless: (1) the corresponding income item was subject to net income tax by Alabama, another state or foreign income tax treaty country in the same tax year; (2) the corporation and the revenue commissioner agree in writing to the application or use of alternative adjustments and computations; (3) the corporation establishes that the adjustments are unreasonable; or (4) the corporation can establish that the transaction giving rise to the expenses/costs did not have as a principal purpose the avoidance of Alabama tax and the related member is not primarily engaged in the acquisition, use, licensing, maintenance, management, ownership, sale, exchange or other disposition of intangible property, or in the financing of related entities; see Act 1088 (HB 2), Laws 2001 (4th Sp. Sess.); Ala. Code [section] 40-18-35(b).

Connecticut: For tax years beginning after 1998, corporations must add back to Federal taxable income interest and intangible expenses/costs directly or indirectly paid to related members, unless the corporation: (1) establishes by clear and convincing evidence that the adjustments are unreasonable; (2) establishes by a preponderance of the evidence that the transaction did not have as a principal purpose the avoid ante of tax and during the same tax year, the related member paid the expense to an unrelated person; or (3) agrees in writing with the commissioner to the use of an alternative apportionment method; see P.A. 98-110, Laws 1998; Conn. Gen. Stat. [section] 12-218c(b) and (c).

The addback is also not required to the extent that increased tax attributable to such adjustments would have been avoided had the corporation and related member timely elected to file a Connecticut combined return.

Mississippi: For tax years beginning after 2000, taxpayers must add back to Federal taxable income interest and intangible expenses/costs directly or indirectly paid to related members, unless the taxpayer can establish: (1) the transaction giving rise to the expense was done primarily for a valid business purpose other than tax avoidance and the related party is not primarily engaged in the acquisition, use, maintenance or management, ownership, sale, exchange or other disposition of intangible property; or (2) the related party paid such expense to an unrelated party; see Ch. 586 (HB 1695), Laws 2001; Miss. Code Ann. [section] 27-7-17(2). The June 30, 2003 sunset for this provision was removed by recent legislation; see SB 2354, Laws 2003.

New Jersey: For tax years beginning after 2001, corporations generally must add back to Federal taxable income interest and intangible expenses/costs directly or indirectly paid to related members; see Ch. 40 (AB 2501), Laws 2002; N.J.S.A. [subsections] 54:10A-4 and 54:10A-4.4. Interest is not required to be added back if: (1) the taxpayer shows by clear and convincing evidence that the recipient is subject to a net income or receipts tax in New Jersey, another state or country at a rate not less than 3% under New Jersey's rate, the interest is included ha the tax measure, the interest was paid at an arm's-length rate and a principal purpose of the transaction generating the interest was not to avoid New Jersey tax; (2) the taxpayer shows by clear and convincing evidence that the deduction disallowance is unreasonable or the taxation division agrees in writing to an alternative apportionment method; or (3) the taxpayer shows by a preponderance of the evidence that the interest was paid either to a related member in a foreign income tax treaty country or to an independent lender (when the taxpayer guarantees the debt on which the interest is paid).

Intangible expenses/costs (including intangibles-related interest expense) are not required to be added back if: (1) the related recipient is in a foreign income tax treaty country; (2) the taxpayer shows by clear and convincing evidence that the addback is unreasonable; (3) The division agrees in writing to an alternative apportionment method; or (4) the taxpayer shows by a preponderance of the evidence that the related party paid the same amount to an unrelated third party ha the same year and the underlying transaction did not have a principal purpose of avoiding New Jersey tax.

North Carolina: Effective Jan. 1, 2001, deductions are disallowed for royalty payments made to related members for the use of trademarks, unless the related member includes the income on a North Carolina return or the taxpayer establishes that the related member paid or accrued the expense to an unrelated person during the tax year; see Ch. 327 (HB 1157), Laws 2001; N.C. Gen. Stats. [subsections] 105-130.5(a)(9) and (14) and 105-130.7A.

Ohio: Beginning with the 1999 tax year, all corporations are required to add back to Federal taxable income interest and intangible expenses/costs paid to specified related members, unless the corporation: (1) establishes by clear and convincing evidence that the adjustments are unreasonable; (2) establishes by a preponderance of the evidence that, during the same tax year, the related member paid or accrued the expense to an unrelated person and the transaction did not have as a principal purpose the avoidance of tax; or (3) agrees in writing with the commissioner to the use of alternative adjustments; see HB 215, Laws 1997; Ohio Rev. Code [section] 5733.042(C) and (D).

The specified related members generally include, under Ohio Rev. Code [section] 5733.042(C), personal holding companies and entities whose activities, in any one state, are primarily limited to the maintenance and management of intangible investments of corporations, business trusts or other entities registered as investment companies, and the collection and distribution of the income from such investments or from tangible property physically located outside of the state.

For tax years prior to 1999, the addback requirement applied only to a corporation that had one or more of the following: (1) gross sales (including sales in other affiliated group members) during the tax year of at least $50 million; (2) total assets with a value at any time during the tax year of at least $25 million; or (3) taxable income before operating loss deduction and special deductions during the tax year of at least $500,000; see Ohio Rev. Code [section] 5733.042(B).

2003 Legislative Activity

Arkansas enacted legislation: For tax years beginning after 2003, interest and intangible expenses paid to a related party are disallowed, unless: (1) the interest or intangibles-related income is subject to net income tax by Arkansas, another state or a foreign income tax treaty country; (2) the income was received pursuant to an arm's-length contract or interest rate and the transaction is not intended to avoid payment of Arkansas income tax; (3) the taxpayer and director enter into a written agreement allowing the deduction or providing an alternative apportionment method; or (4) during the tax year, in a nontax location, the related income recipient operates an active trade or business, has 50 or more full-time equivalent employees, owns real or tangible personal property with a fair market value in excess of $1 million and generates revenues from sources within the nontax state in excess of $1 million; see Act 1286 (SB 334), Laws 2003; Ark. Code/Man. [section] 26-51-423(g) (1).

District of Columbia pending legislation: B 15-243 would disallow interest and intangible expenses/costs paid to related members whose activities are primarily limited to the maintenance and management of trademarks, patents or other intangible assets or investments.

Maryland vetoed legislation: HB 753, which passed, but was vetoed by the governor, would have disallowed deductions for interest and intangible expenses/costs paid to related members, unless the corporation established by clear and convincing evidence that (1) the transaction giving rise to such expenses did not have avoidance of Maryland tax as a principal purpose; (2) the expense was paid pursuant to arm's-length contracts at arm's-length rates/prices and; (3) during the same tax year, either the related member paid or accrued such expense to an unrelated party or the related party was subject to net income or receipts tax in Maryland, another state or country, the income was included in the tax measure and the effective state or foreign rate paid by the related member on the income was at least 4%. Certain addback exceptions also would have been provided for banks and the biotechnology industry.

Massachusetts enacted legislation: For tax years beginning after 2001, corporations generally must add back interest and intangible expenses/costs directly or indirectly paid to related members; see Ch. 4 (SB 1949), Laws 2003; Mass. Gen. Laws [subsections] 311 and 31J.

Interest and intangible expenses/ costs directly or indirectly paid to a related member are not required to be added back if: (1) the corporation proves by a preponderance of the evidence that, during the same tax year, the related member paid or accrued the expenses to an unrelated member and the transaction giving rise to the expense did not have as a principal purpose the avoidance of Massachusetts tax; (2) the corporation establishes by clear and convincing evidence that the adjustment is unreasonable; or (3) the taxpayer and commissioner agree in writing to the use of an alternative apportionment method.

Under a separate rule, interest paid to a related member also is not required to be added back if: (1) the corporation establishes by clear and convincing evidence that the deduction disallowance is unreasonable; (2) the taxpayer and commissioner agree in writing to the application of an alternative apportionment method; or (3) a principal purpose of the transaction giving rise to the expense was not to avoid Massachusetts taxes, the interest is paid pursuant to an arm's-length contract and the related member was subject to state or foreign net income tax on the income at a rate no less than the statutory rate applied to the taxpayer minus three percentage points. Also, interest deductions related to dividend notes and deductions for third-party debt incurred in certain reorganizations are disallowed.

Missouri introduced legislation: HB 503 and companion bill SB 536, neither of which passed, would have disallowed deductions for interest and intangible expenses/costs paid to related members, unless the corporation had established by a preponderance of the evidence that during the same tax year, the related member paid or accrued such expense to an unrelated party and the transaction giving rise to such expenses/costs did not have tax avoidance as a principal purpose.

New York State and City enacted legislation: For tax years after 2002, taxpayers must add back to taxable income interest and royalty expenses paid to related members; see New York State: AB 2106, Part U3, [section] 1, Laws 2003, amending N.Y. Tax Law [section] 208(9)(o)(2) (2003) (governor's veto overridden May 15, 2003). New York City: AB 8388, Part N, Laws 2003, amending N.Y. Tax Law [section] 1201 and NYC Admin. Code [section] 11-602 (governor's veto overridden May 19, 2003).

Interaffiliate royalty expenses are not required to be added back if the transaction was primarily for a valid business purpose other than the avoidance of New York tax and: (1) the related member paid or accrued the amount to an unrelated party or (2) the transaction giving rise to the expense was made pursuant to an arm's-length contract; see N.Y. Tax Law [section] 208(9)(o)(2)(B); NYC Admin. Code [section] 11-602(n) (2)(b).

Interaffiliate interest expenses are not required to be added back if the transaction giving rise to the expense was done for a valid business purpose other than the avoidance of New York tax and (1) the related-member lender uses funds borrowed from, charged or passed through to an unrelated party, to finance the interaffiliate debt on an arm's-length basis; or (2) the debt is part of a regular and systematic funds management or portfolio investment activity conducted by the related member, in which related member funds are aggregated to achieve economies of scale, internal financing or centralized management benefits; see N.Y. Tax Law [section] 208(9)(o)(4)(B); NYC Admin. Code [section] 11-602(n)(4)(b).

A technical corrections bill, which would have repealed the addback for interest expense (other than for that on debt used to finance royalty-related intangibles), surfaced at the end of the legislative session but failed to pass; see 2003 NY AB 9097; 2003 NY SB 5639, 5692.

Ohio introduced legislation: HB 95, as introduced, would have disallowed all expenses paid to related members, and not otherwise paid to an unrelated third party, except when such companies elected to file on a consolidated basis with the same entities as those on their Federal consolidated return. However, these provisions were removed prior to the bill's enactment.

Pennsylvania pending legislation: HB 1305 would disallow deductions for interest and intangible expenses/ costs paid to related members, unless the corporation proves by clear and convincing evidence that the transaction creating the expenses did not have avoidance of Pennsylvania tax as a principal purpose.

Rhode Island introduced legislation: SB 794, which did not pass, would have disallowed deductions for interest and intangible expenses/costs paid to related members, unless: (1) the corporation established by a preponderance of the evidence that, during the same tax year, the related member paid or accrued such expense to an unrelated party and the transaction giving rise to such expenses/costs did not have avoidance of Rhode Island tax as a principal purpose; (2) the corporation established by clear and convincing evidence that the adjustments were unreasonable; or (3) the corporation and tax administrator enter into a written agreement to use an alternative apportionment method.

Texas legislation introduced: Several bills were introduced/modified during the 2003 regular sessions, but none passed. HB 3146 would have required an addback of the following expenses paid to a related entity that was not subject to Texas franchise tax--management fees, amounts paid for use of an intangible and interest.

HB 2425 would have required the addback of any excess (1) management fees, (2) royalty payments and (3) interest payments made to related entities.

Wisconsin pending legislation: AB 391 would disallow deductions for management and service fees, interest and intangibles expenses/costs and any other expenses/costs paid to related entities.

General: During the 2003 state regular sessions, legislation disallowing certain intercompany deductions was introduced in 12 state and local jurisdictions; at present, four of those jurisdictions (Arkansas, Massachusetts, New York State and New York City) enacted such laws, and legislation is pending in an additional three jurisdictions (District of Columbia, Pennsylvania and Wisconsin). Similar legislation will probably be introduced in several states during the 2004 legislative session, as the states that do not require unitary businesses to file under the combined reporting method attempt to limit or eliminate common state tax planning strategies for the payment of royalties or interest to affiliated trademark, trade-name or finance companies.

Authors:

Karen J. Boucher, CPA

Senior Manager

Deloitte & Touche LLP

Milwaukee, WI

John McCown, CPA

Senior Manager

Washington National Tax Office

Deloitte & Touche LLP

Washington, DC
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Author:McCown, John
Publication:The Tax Adviser
Date:Sep 1, 2003
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