State Income Tax Attacks on Intercompany Transactions...─States have several means of scrutinizing intercompany transactions: • Nexus • Statutory disallowance (e.g., addback)

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Chicago Tax Club – Fall Meeting

State Income Tax Attacks on Intercompany Transactions

November 2, 2017

Jennifer ZimmermanWalgreens Company

Marc SimonettiEversheds Sutherland (US) LLP

Nicole BoutrosEversheds Sutherland (US) LLP

Eversheds Sutherland

− Ways States Scrutinize Transactions:

• Nexus

• Statutory disallowance

• Transfer pricing

• Forced combination

• Federal/judicial/common law doctrines

• Tax haven legislation

Agenda

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States Scrutinize Intercompany TransactionsBackground

─ States scrutinize intercompany transactions because of potential income and expense shifting among affiliated group members

─ Disputes arise in separate reporting states, and in combined reporting states where not all affiliates are included in the group

─ Close attention paid to transactions involving IP, debt, management fees, insurance premiums, and goods (inventory)

─ At the federal level, there are mechanisms that address potential income and expenses shifting among affiliated group members, such as consolidated returns and transfer pricing

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Ways States Scrutinize Intercompany Transactions Background

─ States have several means of scrutinizing intercompany transactions:

• Nexus

• Statutory disallowance (e.g., addback)

• Transfer pricing

• Forced combination

• Federal/judicial/common law doctrines (e.g., economic substance, sham transaction)

• Tax haven legislation

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NEXUS


Economic Nexus v. Physical PresenceNexus

─ States have jurisdiction to impose on corporations meeting substantial nexus standards an apportioned income tax that does not discriminate against interstate or foreign commerce

─ Are activities performed in-state by affiliate significantly associated with taxpayer’s ability to establish and maintain an in-state market for sales?

─ Intangible holding company cases like Geoffrey, Inc. v. S.C. Tax Comm'n, 313 S.C. 15 (S.C. 1993), were among the first to hold that economic nexus is sufficient for corporate income tax purposes

─ By asserting that out-of-state affiliate has economic or attributional nexus, states can undo intercompany transactions that shift income outside the state

─ Keep an eye on pending Quill challenges for any potential guidance

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Crutchfield (OH) – Factor Presence NexusNexus

─ Ohio adopted factor nexus provision for CAT purposes

─ The Department claimed the CAT is not governed by Quillbecause it is not a sales and use tax

─ The Department also argued that the physical presence was met because of software and “cookies” placed on in-state customers’ computers

─ On November 17, 2016, the Ohio Supreme Court upheld the factor nexus provision because the Quill physical presence nexus standard does not extend to business-privilege taxes such as the CAT• The court distinguished that physical presence is a sufficient, but

not necessary, condition to impose a business privilege tax

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Crutchfield, Inc., v. Testa, Nos. 15-0386, 15-0483, 15-0794, 2016 WL 6775765 (Ohio 2016).


Avnet (WA) – No Transactional Nexus NeededNexus

─ The Washington Supreme Court held that drop shipments and sales from out-of-state are subject to the Washington business and occupation (B&O) tax even when an in-state office was not involved in placing or completing the sales

─ The taxpayer sold products through its Arizona headquarters and its regional sales offices, including one in Washington, but excluded its national and drop-shipped sales from its B&O tax liabilities

─ The dormant Commerce Clause was satisfied because the Washington employees’ activities (i.e., providing Washington market intelligence, meeting with sales teams and suppliers, and working with customers for product improvement) were associated with establishing and maintaining a Washington market for the sale of its products

─ Note: On October 2, 2017, the US Supreme Court declined to review a different Washington Supreme Court decision denying review of a lower court opinion rejecting the taxpayer’s argument that the Commerce Clause prohibited the state from imposing the B&O tax and from sales tax collection because the taxpayer’s retail sales were dissociated from its in-state wholesale activities

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Avnet, Inc. v. Wash. Dep’t of Revenue, 187 Wash.2d 44 (Wash. 2016); Irwin Naturals v. Dep't of Revenue, 382 P.3d 689, (Wash. App. Ct 2016), review denied, 388 P.3d 1256 (Wash. 2017), cert. denied, No. 17-91 (Oct. 2, 2017).


STATUTORY DISALLOWANCE


BackgroundStatutory Disallowance

─ Addback statutes disallow otherwise allowable deductions for expenses paid to affiliates

─ Common exceptions to addback statutes include:• Recipient subject to tax on income in excess of a benchmark rate• Recipient is in a foreign country with US income tax treaty• Specific industry exceptions• Recipient is a conduit for payment to third parties• Parties elect to file on a combined basis• Unreasonable exception

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Kohl’s (VA) – “Subject to Tax” Addback ExceptionStatutory Disallowance

─ The Virginia Supreme Court found that only the portion of royalties that are actually taxed by another state falls within the state’s “subject to tax” exception to its addback statute for corporate income tax purposes• The court acknowledged that the plain language of the statute is

ambiguous and that both parties’ respective positions could be supported by the statute

─ The court deferred to the Department’s interpretation

─ The case has been remanded to the Circuit Court to determine the portion of the royalty payments actually taxed by another state

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Kohl’s Dep’t Stores, Inc. v. Va. Dep’t of Taxation, No. 160681 (Va. Aug. 31, 2017).


Credit Suisse (AL) – Meeting the Treaty ExceptionStatutory Disallowance

─ The Tax Tribunal affirmed the Department’s additional 2016 business income tax assessment related to the taxpayer’s denied deductions for interest expenses paid to related members

─ The Tribunal found:• The taxpayer failed to meet the “treaty exception” because it

failed to provide necessary documentation to show that the interest expenses paid to related companies were subject to a tax in a foreign jurisdiction that had an income tax treaty with the US

• The taxpayer did not meet its burden to show that the transactions giving rise to the interest expenses had a substantial business purpose, economic substance, and arm’s length terms and conditions

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Credit Suisse First Boston USA Inc. v. Ala. Dep’t. of Revenue, No. BIT. 15-1666 (Ala. Tax Tribunal, Sept. 7, 2017).


Kraft (NJ) – Pushed-Down Debt Subject to AddbackStatutory Disallowance

─ Parent corporation took on third-party debt and allocated it to the operating subsidiary

─ Division asserted that the interest payments made to the parent were subject to addback; Kraft counter that the debt issued by parent was essentially subsidiary’s debt and that the interest payments were a legitimate business expense

─ New Jersey Tax Court determined that the Division correctly required the taxpayer to add back related party interest payments, holding that the taxpayer did not prove by clear and convincing evidence that addback was unreasonable

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Beneficial & Morgan Stanley (NJ) – Hurdles for 3% ExceptionStatutory Disallowance

─ New Jersey’s 3% exception for interest addback requires, in part, the rate of tax applied to the interest income is “equal to or greater than a rate three percentage points less than” the taxpayer’s New Jersey rate of tax

─ In Beneficial, the Tax Court of New Jersey found that the 3% exception did not apply, but the unreasonable exception applied because the intercompany borrowing had economic substance and a valid business purpose• For the 3% exception, “rate of tax” interpreted to mean the

effective tax rate

─ In Morgan Stanley, the Tax Court of New Jersey found the unreasonable exception applied because under the “totality of the circumstances” it would result in unfair duplicative taxation

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Beneficial New Jersey v. Dir., Div. of Taxation, No. 009886-2007 (N.J. Tax Ct. 2010); Morgan Stanley & Co., Inc. vs. Dir., Div. of Taxation, 28 N.J. Tax 197 (N.J. Tax Ct. 2014).


BMC Software (NJ) – Satisfying the Unreasonable ExceptionStatutory Disallowance

─ New Jersey law generally requires royalty payments for intangible property made by a subsidiary to a parent company to be added back to the subsidiary's income for tax purposes

─ But the New Jersey Tax Court found that while amounts a wholly-owned subsidiary paid BMC Software, Inc. for licensing and distributing software qualified as such payments, a deduction for these payments should be allowed since they are “substantively equivalent” to payments that either BMC or its subsidiary would make to unrelated third parties for similar software license and service contracts• The unreasonable exception does not require showing that the

related-party recipient paid Corporation Business Tax on the income

─ Thus, the payments qualified as an exception to the add-back statute

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BMC Software Inc. v. Dir., Div. of Taxation, No. 000403-2012 (N.J. Tax Ct. 2017).


TRANSFER PRICING


States’ Transfer Pricing AuthorityTransfer Pricing

─ Many states have statutes that adopt or are substantially similar to IRC § 482

─ Some states assert statutory language broader than IRC § 482 authority

─ Some states with no IRC § 482 equivalent assert their right to adjust intercompany pricing by asserting general federal conformity or general discretionary authority

─ Nearly every state adopts some statutory regime to adjust prices of intercompany transactions• Notable states that do not: Delaware, New Mexico, and

Pennsylvania

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See’s Candies (UT) – Abuse of DiscretionTransfer Pricing

─ Subsidiary of a large conglomerate deducted IP royalty payments made to an insurance company also owned by the conglomerate

─ The Tax Commission argued that it could adjust the subsidiary’s income for the royalty payments based on the state’s 482-style adjustment statute without reference to federal rules on related-company adjustments

─ The Utah District Court found that the Tax Commission abused its discretion by denying the entire intercompany royalty expenses when the Tax Commission failed to consider federal 482 guidance and failed to look at the taxpayer’s transfer-pricing study

─ On appeal at the Utah Supreme Court

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See’s Candies, Inc. v. Auditing Div. of the Utah State Tax Comm’n, No. 140401556 (Utah Dist. Ct. 2016).


Rent-A-Center & Columbia Sportswear (IN) – Fair Reflection of Income

Transfer Pricing

─ Rent-A-Center East, Inc. – Indiana Tax Court rejected the DOR’s long-standing position that transfer pricing studies are not relevant to whether a separate return fairly reflects Indiana source income because Indiana’s transfer pricing statute mirrors the language of § 482• Held that Rent-A-Center East, Inc. did not have to file a combined

return with its out-of-state affiliates Rent-A-Center West and Rent-A-Center Texas because the record did not show that RAC East engaged in any tax avoidance measures and its intercompany transactions were at arm’s-length rates as determined by an independent transfer pricing study

─ Columbia Sportswear – Indiana Tax Court concluded that because Columbia’s transfer pricing studies demonstrated that its intercompany transactions were conducted at arm’s length rates, its Indiana income was fairly reflected for purposes of Indiana’s transfer pricing statute

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Rent-A-Center East, Inc. v. Dep’t of Revenue, No. 49T10-0612-TA-00106 (Ind. Tax Ct. Sept. 10, 2015); Columbia Sportswear USA Corp., v. Indiana Dep’t of Revenue, No. 49T10-1104-TA-00032 (Ind. Tax Ct. Dec. 18, 2015)


Multistate Tax Commission’s “SITAS” ProjectTransfer Pricing

─ A committee of the MTC developed a transfer-pricing program that would be available to the states.

─ MTC Executive Committee approved the Final Program Design in May 2015, originally called Arms-Length Adjustment Services (ALAS); subsequently re-branded to State Intercompany Transactions Advisory Service (SITAS) in August 2016.

─ Recent transfer pricing cases have been cited as a reason for a multistate program.

─ SITAS is designed to: • Provide training for state staff to identify distorting intercompany

transactions; and • Provide third-party support to combat transfer-pricing studies

provided by taxpayers.

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Multistate Tax Commission’s “SITAS” ProjectTransfer Pricing

─ The program was designed to launch with the support of 10 states, although only 5 states have signed on to the program• Alabama, Iowa, New Jersey, North Carolina, and Pennsylvania

─ SITAS now functions as an informal vehicle to facilitate state cooperation• SITAS encourages ad hoc cooperation among states• States working amongst themselves to address issues

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FORCED COMBINATION


OverviewForced Combination

─ Many states require unitary groups file combined report; states may contend existence of a unitary group to impose a combined filing

─ Some separate reporting states will permit or require combined reports (or separate accounting) if necessary to properly reflect income attributable to the state

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Worldwide Reporting v. Water’s Edge ReportingForced Combination

─ Worldwide combined reporting • Held constitutional in Container and Barclays Bank, but no state

generally requires worldwide combined reporting without providing water’s edge election

─ Water’s-edge reporting• May be elected in several states—e.g., California, Idaho, Utah,

Massachusetts• Required in many states—e.g., Illinois, Wisconsin, Michigan,

Minnesota• Generally excludes foreign affiliates with 20% or less activity in US• May be measured by sales or combination of factors• Includes (in CA) certain Subpart F income of non-US members• Some states include non-US members that earn more than 20% of

income from intangible property or services-related activities that are deductible by other members, to extent of income and apportionment factors

• Other states exclude foreign and US companies if 80% or more of the business activity is outside of the US

• Includes (in some states) entire income of member doing business in a tax haven

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HMC-New York (NYC) – Forced Combination UpheldForced Combination

─ A New York City Administrative Law Judge (ALJ) upheld the New York City Department of Finance’s forced combination of a hedge fund group for New York City General Corporation Tax (GCT) purposes

─ The ALJ determined a combined report was required due to substantial intercorporate transactions and the presence of distortion

─ The ALJ determined that the taxpayer’s transfer pricing analysis was not convincing (citing to flaws in the analysis) to overcome the presumption of distortion arising from substantial intercorporate transactions

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In the Matter of the Petition of HMC-New York Inc., Det. TAT (H) 14-15 (GC) (New York City Tax App. Trib. Apr. 27, 2017).


Ashland (MN) – Inclusion of a Foreign Disregarded EntityForced (De-)Combination

─ The Minnesota Supreme Court affirmed that an election made under federal tax law by a foreign entity owned by the taxpayer, a domestic unitary business, must be recognized in determining the taxpayer's Minnesota tax liability

─ The court rejected the Department’s attempt to include the foreign disregarded entity’s income• Including in “net income” the income of a foreign entity that elects under federal tax law to be treated as a disregarded entity does not violate Minnesota’s water’s edge law because the disregarded entity does not retain a nationality separate from its owner under Minnesota tax law

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Ashland, Inc. v. Comm’r of Revenue, No. A16-1257 (Minn. Aug. 2, 2017).


FEDERAL/JUDICIAL/COMMON LAW DOCTRINES


OverviewFederal/Judicial/Common Law Doctrines

─ State courts and administrative bodies may examine intercompany transactions under the lens of federal doctrines:• Sham transaction

• See Syms Corp. v. Comm’r of Revenue, 436 Mass. 505 (2002); Sherwin-Williams Co. v. Comm’r of Revenue, 438 Mass. 71 (2002).

• Economic substance/business purposes• Business purpose: Transactions must have a bona fide business purpose apart

from tax avoidance (subjective inquiry)• Economic substance: Whether there is the possibility of a profit, and whether

the transaction is a mere book entry (objective inquiry)

─ Genuine indebtedness (Fin Hay factors)• See Nat’l Grid Holdings, Inc. v. Comm’r of Revenue, 89 Mass. App.

Ct. 506 (Mass. App. Tax Bd. 2016); Mass. Mutual Life Ins. Co. v. Comm’r of Revenue, No. C305276 (Mass. App. Tax Bd. June 12, 2015)

─ Ordinary and necessary expense

─ IRC § 385 regulations

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IRC § 385: Overview of Debt-Equity RegulationsFederal/Judicial/Common Law Doctrines

─ On October 13, 2016, the Department of Treasury (Treasury) and IRS issued final and temporary regulations under IRC § 385 (Final Regulations)• The Final Regulations address the characterization of certain debt

for US tax purposes and are intended in part to prevent earnings stripping

─ Here to stay?• On July 7, 2017, the Treasury issued Notice 2017-38, which

identifies 8 tax regulations, including the Final Regulations, for potential repeal or modification under President Trump’s executive order 13789, seeking tax code simplification

• On October 4, 2017, Treasury issued its Second Report, which provides details on the repeal/modification of the Final Regulations

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IRC § 385: Final RegulationsFederal/Judicial/Common Law Doctrines

─ The Final Regulations provide the following:• Reaffirm application of existing case law debt-equity principles • Impose additional rules for related-party debt:• New documentation requirements (Documentation Rules)• Equity recast rules for related-party debt issued in connection

with certain transactions (Distribution Rules)

─ Generally applies to debt among members of an expanded corporate group, which includes certain controlled partnerships

─ Do not apply to:• Obligations issued by foreign corporations• Obligations between members of a federal consolidated group

─ Federal consolidated group members are treated as a single taxpayer for purposes of applying the rules

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IRC § 385: Documentation RulesFederal/Judicial/Common Law Doctrines

─ Under the Final Regulations, the Documentation Rules require that taxpayers prepare and maintain certain contemporaneous documents to support related-party debt instruments issued after January 1, 2019

─ Under the Second Report, the Treasury and IRS are considering a proposal to revoke the Documentation Rules and replace it with “substantially simplified and streamlined” documentation rules

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IRC § 385: Distribution RulesFederal/Judicial/Common Law Doctrines

─ Under the Final Regulations, the Distribution Rules address earning stripping by recasting certain related-party debt instruments issued in connection with certain transactions as equity• Designed to target specific transactions (e.g., intragroup note

distributions and economically similar transactions)

─ Under the Second Report, the Distribution Rules will remain as is, until federal tax reform legislation entirely eliminates the need for the Distribution Rules• If federal tax reform legislation does not eliminate the need for

the Distribution Rules, then more streamlined and targeted regulations may be proposed

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IRC § 385: State Tax ConsiderationsFederal/Judicial/Common Law Doctrines

─ Will states focus more on case law debt-equity principles?

─ Will states seek to apply the Distribution Rules as a tool to disallow interest deductions on intercompany debt?

─ Will states adopt their own Distribution Rules?

─ Related-party debt recast as equity for federal income tax purposes may result in:• A different composition of the state combined/consolidated group• Federal/state stock basis differences

─ A recast from debt to equity for state income tax purposes may carry over from state income for franchise tax purposes

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TAX HAVEN LEGISLATION


Legislation Designed to Tax Foreign Source IncomeTax Haven Legislation

─ Because states do not employ a source-based methodology, states argue that outbound profit-shifting techniques to tax haven countries leads to state tax base erosion; tax haven legislation is intended to close that gap

─ Six states (AK, CT, MT, OR, RI, and WV) plus the District of Columbia currently have some form of “tax haven” provision

─ Two approaches: • Blacklist: Defining a “tax haven” by maintaining a statutory list of

foreign jurisdictions• Criteria: Employ a facts and circumstances test that looks to

certain criteria, typically modeled after the Multistate Tax Commission’s “tax haven” definition in the combined reporting model statute

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Problems with Tax Haven LegislationTax Haven Legislation

─ Lists are based on an outdated OECD list developed for transparency and information sharing

─ Not limited to island economies; includes low tax rate and other tax favorable characteristics

─ Lists create huge disincentive for foreign direct investment

─ Flawed premise that profits booked to identified countries are per se tax evasion

─ Potential constitutional infirmity (and guaranteed litigation) resulting from tax haven legislation

─ Does only the foreign gross income of the “tax haven” entity get included?• Note, Oregon's 2015 law deleted the requirement to include in the

combined report the apportionment factors of a “tax haven” entity

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Questions?

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Contact us

Jennifer ZimmermanWalgreens [email protected]

Marc A. SimonettiEversheds Sutherland (US) [email protected]

Nicole BoutrosEversheds Sutherland (US) [email protected]

Documents

State Income Tax Attacks on Intercompany Transactions...─States have several means of scrutinizing intercompany transactions: • Nexus • Statutory disallowance (e.g., addback)