Continued trend toward state related-party expense addback.

• Author: Sakurai, Edward

In recent years, several states have enacted provisions requiring the addback of certain related-party expenses. These provisions are intended to combat the use of related-party transactions to reduce the taxable income of an affiliated company that files in a separate-company reporting state and reflect the continued trend by states to enact some form of related-party expense addback. The trend started in the 1990s and accelerated into the early 2000s. Since 2005, six additional states have enacted legislation limiting the deductibility of related-party expenses, with the latest being Michigan, Rhode Island, and Wisconsin, whose provisions are effective for 2008 tax years.

In the past, taxpayers have been able to take deductions for certain expenses payable to related parties, including interest and expenses relating to the licensing of intangibles. These deductions could have the effect of lowering taxpayers' overall state tax burden.

For example, a company would transfer its valuable intangibles into a separately incorporated subsidiary. That subsidiary typically would be organized in Delaware, which does not tax such companies. The subsidiary could also be organized in a state with no state income tax, such as Nevada. There is also benefit derived if the subsidiary is organized in a combined reporting state. The intangible company would license its intangibles to the operating company and charge the operating company a royalty or license fee. The operating company would take a deduction for the expense on its separate company state tax return, but the recipient of the income--the intangible company--would not pay tax on the corresponding income because such income is not subject to tax.

To combat this type of tax planning, states have enacted provisions that disallow the deduction of these related-party expenses. The common targets of such disallowance are interest expenses and expenses related to the licensing of intangibles.

Recognizing that in certain circumstances there is a legitimate business purpose behind related-party financing arrangements and intangible licensing arrangements, states generally provide exceptions where addback is not required by the payor. These exceptions vary depending on the state, but some common exceptions include:

* Where the principal purpose of the arrangement is not tax avoidance, the transaction is made at arm's-length rates, or the taxpayer shows that the adjustment is unreasonable;

* Where the...