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IRC § 385, Intercompany Transactions, and Related Matters – Preparing for Continued Scrutiny24th Annual Paul J. Hartman State and Local Tax Forum

November 7, 2017Alexis Morrison-HoweSenior Manager, Washington National Tax, Deloitte Tax LLP

Michael FataleDeputy General Counsel, Massachusetts Department of Revenue

Jeff FriedmanPartner, Eversheds Sutherland (US) LLP

− Background

− Ways States Scrutinize Transactions• Nexus

• Statutory disallowance

• Transfer pricing

• Forced combination

• Tax haven legislation• Federal/judicial/common law doctrines

• IRC § 385 debt-equity regulations

Agenda

− Viewpoint• Alexis Morrison-Howe

• Michael Fatale

• Jeff Friedman

− Disclaimer• The descriptions, views and opinions expressed in this

presentation are not necessarily of the presenters or of Deloitte Tax LLP, the Massachusetts Department of Revenue, or Eversheds Sutherland (US) LLP

Viewpoint and Disclaimer

States Scrutinize Intercompany Transactions

Background

─ 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 and transfer pricing)

• Statutory & forced combination

• Tax haven legislation

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

• IRC § 385 regulations

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Nexus

Economic Nexus v. Physical Presence

Nexus

─ 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 Quill challenges for any potential guidance

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Crutchfield – Factor Presence Nexus

Nexus

─ 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 distinguishes that physical presence is a sufficient

condition to impose a business-privilege tax, but not a necessary one

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

No Transactional Nexus Needed

Nexus

─ 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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[TAXPAYER], 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

Background

Statutory Disallowance

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

─ Common exceptions to addback statutes• Unreasonable exception• 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

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“Subject to Tax” Addback Exception

Statutory 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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[Taxpayer], Inc. v. Va. Dep’t of Taxation, No. 160681 (Va. Aug. 31, 2017).

Credit Suisse – Meeting the Treaty Exception

Statutory 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).

BMC Software – Satisfying the Unreasonable Exception

Statutory 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, in the Tax Court of New Jersey (N.J. Tax Ct. 2017).

Transfer Pricing

Most States Have Transfer Pricing Authority

Transfer 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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Abuse of Discretion

Transfer 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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[TAXPAYER], Inc. v. Auditing Div. of the Utah State Tax Comm’n, No. 140401556 (Utah Dist. Ct. 2016).

MTC’s Transfer Pricing Initiative

Transfer Pricing

─ Previously known as the ALAS (Arm’s Length Adjustment Service) Committee

─ In August 2016, name was changed to garner increased state participation

─ Critical component of the program is the Participation Commitment and Exchange of Information Agreement.• Permits states to exchange tax returns, audit reports, nexus

questionnaires, and other related workpapers• Also permits sharing of “proprietary taxpayer information”

─ SITAS continues to seek state interest and support

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Combination

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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Overview

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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Worldwide Reporting v. Water’s Edge Reporting

Combination

─ Filing methods – 80/20 companies• Measured by payroll, property, and/or sales

─ Rules vary by state, but generally excludes foreign affiliates from combined report• Which foreign entities are included/excluded• Whether foreign entity should include only US source income• Whether 80/20 rule should include domestic entities• Effect on intercompany transactions between domestic and

foreign affiliates

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Water’s Edge Election

Inclusion of a Foreign Disregarded Entity

(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

─ Including in “net income” the income of a foreign entity that elects under federal tax law to be disregarded as a separate 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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[TAXPAYER], Inc. v. Comm’r of Revenue, No. A16-1257 (Minn. Aug. 2, 2017).

HMC-New York Inc. – Forced Combination Upheld

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).

Tax Haven Legislation

Legislation Designed to Tax Foreign Source Income

Tax Haven Legislation

─ 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

─ Concern: 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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Federal/Judicial/Common Law Doctrines

Overview

Federal/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 Debt-Equity Regulations

IRC § 385 Regulations – Overview

─ 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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Final Regulations

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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Documentation RulesWhat’s Left After the Second Report?

─ 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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Distribution RulesWhat’s Left After the Second Report?

─ 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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State Tax Considerations

─ 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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Questions?

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This communication cannot be used for the purpose of avoiding any penalties that may be imposed under federal, state or local tax law.

Contact us

Alexis Morrison-HoweSenior Manager, Washington National TaxDeloitte Tax LLP617.437.2345alhowe@deloitte.com

Michael FataleDeputy General Counsel Massachusetts Department of Revenue617.626.3259 fatale@dor.state.ma.us

Jeff FriedmanPartner Eversheds Sutherland (US) LLP202.383.0718JeffFriedman@eversheds-sutherland.com