The ins and outs of related party add-backs.

• Author: Sutton, Giles

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...