Continued Trend Toward State Related-Party Expense Addback

By Edward Sakurai, CPA, J.D., Tax Senior Manager, Singer Lewak LLP, Los Angeles, CA (not affiliated with CPAmerica International)

Editor: Michael D. Koppel, CPA, PFS

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 relatedparty 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 corresponding income is subject to tax (many states provide that no addback is required where the related member is subject to a net income or capital-based tax by that state, another state, or a foreign government; some states require that the income be taxed at a certain rate);
  • Where the corresponding income is paid by the recipient to an unrelated third party (the recipient merely acts as a conduit in the ultimate payment to a third party);
  • Where the taxpayer enters into an agreement to use an alternative apportionment method.

Michigan

The Michigan business tax (MBT) has been enacted and replaces the Michigan single business tax (SBT) effective January 1, 2008. The SBT did not require an addback for related-party expenses, but the new MBT requires an addback for any royalty, interest, or other expense paid to a person related to the taxpayer for the use of an intangible asset if that person is not included in the taxpayer's unitary business tax return (MI Comp. Laws §208.1201(2)(f)). The new MBT requires unitary groups to file a combined return (MI Comp. Laws §208.1511).

Addback is not required if the taxpayer can demonstrate that the transaction has a nontax business purpose other than the avoidance of tax, is conducted with arm's-length pricing and rates as applied in accordance with Secs. 482 and 1274(d), and meets one of the following requirements:

  1. The transaction is a passthrough of another transaction between a third party and the related person with comparable rates and terms;
  2. The transaction results in double taxation; or
  3. The addback is unreasonable as determined by the treasurer.

Rhode Island

Rhode Island has enacted legislation requiring the addback of related-party expenses effective for tax years beginning on or after January 1, 2008. Specifically, Rhode Island now requires an addback of otherwise deductible interest and intangible expenses paid or accrued to related parties (RI Gen. Laws §44-11-11(f)).

Addback is not required where:

  • The taxpayer establishes by clear and convincing evidence that the adjustments are unreasonable or the taxpayer agrees to use an alternative apportionment method;
  • The taxpayer establishes by a preponderance of the evidence that the related member paid or accrued the income to an unrelated third party and the transaction did not have a significant purpose of tax avoidance; or
  • The taxpayer establishes by clear and convincing evidence that (a) the purpose of the transaction giving rise to interest expense was not tax avoidance, (b) the interest was paid at an arm's-length rate, and (c) the related member was subject to tax on its net income in Rhode Island or another state or possession of the United States or a foreign nation, the measure of tax included the interest received, and the effective tax rate applied to the interest was not less than the effective rate applied to the taxpayer minus 3%.

    Wisconsin

    Effective for tax years beginning on or after January 1, 2008, Wisconsin requires that interest and rent expenses paid, accrued, or incurred to a related party must be added back (WI Stat. §71.26(2)).

    Addback is not required if the amount is disclosed and:

    1. The related party to which the taxpayer paid, accrued, or incurred the interest or rental expenses paid, accrued, or incurred such amounts to an unrelated party;
    2. The related party was subject to tax on, or measured by, its net income in Wisconsin or any other state, U.S. possession, or foreign country, and the aggregate effective tax rate applied to the income is at least 80% of the taxpayer's aggregate effective rate; or
    3. The taxpayer establishes that the transaction has a business purpose other than the avoidance or reduction of tax, the transaction changed the taxpayer's economic position in a meaningful way apart from the tax effects, and the interest and/or rental expenses were paid at an arm's-length rate (WI Stat. §71.80(23)).

    Conclusion

    To date, almost half the states have provisions requiring addback of relatedparty expenses. Taxpayers can expect that along with the enactment of these provisions, increased audit activity will follow. Because each state's provisions requiring addback of related-party expenses, as well as the exceptions to addback, differ, a thorough understanding of each state's provisions is imperative to avoid unexpected tax exposure. 
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    EditorNotes

    Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.

    The Tax Adviser would like to acknowledge the special contribution to the December Tax Clinic of Singer Lewak LLP; Mark G. Cook, tax partner in the Irvine, CA, office; and Steve Cupingood, the partner in charge of that firm's tax practice.

    For additional information about these items, contact Mr. Koppel at (781) 407-0300 or mkoppel@gggcpas.com.

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