Hold the Intercompany Transactions – State and Local Tax

© 2017 Eversheds Sutherland (US) LLP

All Rights Reserved. This communication is for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making any decisions or taking any action concerning the matters in this communication. This communication does not create an attorney-client

relationship between Sutherland and the recipient. Eversheds Sutherland (US) LLP and Eversheds Sutherland (International) LLP, together with their controlled, managed, affiliated and member firms, are separate legal entities that operate in combination under the name and brand Eversheds Sutherland. For a full description of our structure and a list of our offices, please visit www.eversheds-sutherland.com.

Hold the Intercompany Transactions –State and Local Tax Considerations

Current Issues in State & Local TaxationTEI Philadelphia ChapterFebruary 22, 2017

Open Weaver BanksAndrew Appleby

Eversheds Sutherland

− Background

− Ways States Attack or Undo Effect of Intercompany Transactions

• Nexus

• Federal/judicial doctrines

• Statutory disallowance (addback and transfer pricing)

• Forced combination

• Tax haven legislation

Agenda


States Scrutinize Intercompany Transactions

Background

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

─ Disputes arise primarily in separate reporting states

─ Close attention paid to transactions involving IP, debt, and management fees

─ 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

3


Ways States Attack or Undo Intercompany Transactions

Background

─ States have several means of combating intercompany transactions

• Assert nexus with the out-of-state related entity

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

• Statutory disallowance (e.g., addback and transfer pricing)

• Forced combination

• Tax haven legislation

4


Nexus


No Physical Presence? No Problem!

Nexus

─ 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 (SC) 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, states can undo intercompany transactions that shift income outside the state

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

6

See, e.g., Gore Enterprise Holdings, Inc. v. Comptroller of the Treasury, 87 A.3d 1263 (Md. 2014).


Applying Federal/Judicial Doctrines


Overview


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

• Economic substance/business purposes

• Genuine indebtedness (Fin Hay factors)

• Ordinary and necessary expense

• IRC § 385 Regulations

8


Syms & Sherwin-Williams - Sham Transaction Cases


─ Both cases involved intangible holding company (IHC) structures

─ Despite using the sham transaction doctrine in both, the Massachusetts Supreme Judicial Court reached different results

─ In Syms, there was no practical economic effect other than the creation of a tax benefit and tax avoidance was the motivating factor and only purpose

─ In Sherwin-Williams, the IHCs did business with unrelated third parties, royalties were reinvested in ongoing business, and IHCs assumed and paid expenses of defending IP assets

9

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


Business Purpose and Economic Substance Doctrines


─ 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)

─ Wide body of federal case law• Both economic substance and business purpose

• Either economic substance or business purpose

• One informs the other

10


Gore – IHCs Lack Economic Substance


─ Maryland Court of Appeals held that state may tax out-of-state IHCs that license IP to parent doing business in state when IHCs lack economic substance as separate business entities

─ Court conflated unitary business principle with economic substance and business purpose doctrines

─ Does a corporation have to file a Maryland tax return if it engages in intercompany transactions with in-state parent?

─ Gore decision used as basis for subsequent ConAgra decision

11

Gore Enter. Holdings, Inc. v. Comptroller of the Treasury, 87 A.3d 1263 (Md. 2014); ConAgra Brands, Inc. v. Comptroller of the Treasury, No. 09-IN-OO-0150 (Md. Tax Ct. Feb. 24, 2015).


Mass Mutual – Intercompany Notes Evidence True Debt


─ Massachusetts Appellate Tax Board held that intercompany interest payments from a wholly owned subsidiary to MassMutual were bona fide loans and deductible for excise tax purposes

─ Notes satisfied Massachusetts’ definition of bona fide debt

─ Board applied the 16-factor test articulated in Fin Hay to determining how to characterize the intercompany transfer

12

Mass. Mutual Life Ins. Co. v. Comm’r of Revenue, No. C305276 (Mass. App. Tax Bd. June 12, 2015); Fin Hay Realty Co. v. Comm’r of Internal Revenue, 398 F.2d 694 (3rd Cir. 1968).


National Grid – No Unqualified Obligation to Repay? No True Debt.


─ Intercompany deferred subscription agreements were meant to constitute debt for U.S. purposes and equity for U.K. purposes

─ Massachusetts appeals court held that agreements were not true debt, even though they were treated as liabilities on the company’s financial statements, because there was no unqualified obligation to repay

─ Court also said that a change in federal taxable income does not automatically result in a change to state net income; so, even though a portion of the payment was treated as deductible interest expense in the company’s closing agreement with the IRS, for state tax purposes either all of the payments were interest or none were

13

Nat’l Grid Holdings, Inc. v. Comm’r of Revenue, 89 Mass. App. Ct. 506 (2016).


Ordinary and Necessary Expense


─ Despite conforming to federal law, states may audit above the line and question whether certain expenses are “ordinary and necessary”

14


State Impact of IRC § 385 Regulations


─ On October 13, 2016, the IRS issued Final and Temporary Regulations under IRC § 385 (T.D. 9790)• Reaffirm application of existing case law debt-equity principles

• Impose additional rules for related-party debt:• New documentation requirements

• Equity recast rules for related-party debt issued in connection with certain transactions

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

• Consolidated group members are treated as a single taxpayer for purposes of applying the rules

15


State Impact of IRC § 385 Regulations


─ Regulations are likely to impact state income taxes, particularly over the long term

─ Separate reporting states might seek to apply the Regulations as a tool to disallow interest deductions on intercompany debt

─ In combined reporting states:• Ownership percentages of subsidiaries could be changed by recast equity and result in a different composition of the combined/consolidated group

• Recast equity may cause federal/state stock basis differences

─ For franchise taxes, a recast from debt to equity for state income tax purposes may carry over from income for franchise tax purposes

16


Statutory Disallowance

17


Background


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

─ Common exceptions to addback statutes• 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

─ Transfer pricing

18


Kohl’s – Court Bungles “Subject to Tax” Exception


─ Royalties paid to related members must be added back to a taxpayer’s federal taxable income unless such payments “are subject to a tax based on or measured by net income or capital”

─ Virginia trial court said that even where royalties are reported by related members to other states, royalty payments do not qualify for the addback exception unless those other states actually tax them

─ The Virginia Supreme Court granted review on October 31, 2016

19

Kohl’s Dep’t Stores, Inc. v. Va. Dep’t of Taxation, No. Cl12-1774 (Va. 13th Jud. Cir. Ct. Feb. 3, 2016).


Kraft – Pushed-down Debt Subject to Add-Back


─ 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

20

Kraft Foods Global, Inc. v. Dir., Div. of Taxation, 29 N.J. Tax 224 (2016).


Beneficial & Morgan Stanley – Hurdles for 3% Exception


─ 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

21

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).


Courts Reigning in Use of State Transfer Pricing Adjustments


─ In Rent-A-Center East, the Indiana Tax Court rejected forced combination and partially relied on the taxpayer’s transfer pricing study

─ In See’s Candy, the Utah District Court found that the Utah State Tax Commission abused its discretion by denying the taxpayer’s entire intercompany royalty expenses when the transfer was supported by a transfer pricing study

─ States are using transfer pricing authority to scrutinize intercompany management fee arrangements

22

Rent-A-Center East, Inc. v. Indiana Dep’t of Revenue, No. 49T10-0612-TA-00106 (Ind. Tax Ct. 2015); See’s Candies, Inc. v. Auditing Div. of the Utah State Tax Comm’n, No. 140401556 (Utah Dist. Ct. 2016).


Forced Combination

23


Using Forced Combination to Undo Economic Effect of Intercompany Transactions

Forced Combination

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

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

24


AIG – Success Against Involuntary Combination

Forced Combination

─ After conducting a unitary analysis, the AIG insurance group (AIG) determined that it improperly filed its Vermont tax return with its wholly owned ski resort subsidiary

─ The Department rejected AIG’s amended return and argued that the ski resort subsidiary was a part of the same unitary group

─ Vermont Supreme Court held that AIG was not unitary with its wholly owned ski resort subsidiary• Applying Mobil, the court found that the ski resort subsidiary was a distinct business operation from AIG and there was not enough evidence to support a “linkage of economic realities”

25

AIG Ins. Mgt. Serv. Inc. v. Dep’t of Taxes, 134 A.3d 1232 (Vt. 2015).


Specific Applications

Forced Combination

─ 80/20 Companies

─ Captive Insurance Companies

26


SunGard – Cash Sweep = Combination

Forced (De-)Combination

─ Use of non-arm’s length, interest-free component of cash management system resulted in a flow of value, supporting unitary determination, and also established distortion; taxpayer was entitled to refunds based on filing combined returns

27

In re SunGard Capital Corp., Dkt. Nos. 823631, 823680, 824167, 824256 (N.Y.S. Tax App. Trib. May 19, 2015).


Tax Havens

28


Legislation Designed to Tax Foreign Source Income

Tax Havens

─ Due to the fact that 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

29


Problems with Tax Haven Legislation

Tax Havens

─ 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

30


Questions?

31

Open Weaver BanksEversheds Sutherland (US) LLP

[email protected]

Andrew ApplebyEversheds Sutherland (US) LLP

[email protected]

Documents

Hold the Intercompany Transactions – State and Local Tax