Finding the Gaps, the Nooks, and the Crannies in This Year s Anti-PIC 1 Legislation

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1 AUGUST 2004 Finding the Gaps, the Nooks, and the Crannies in This Year s Anti-PIC 1 Legislation By Kenneth H. Silverberg and Nicholas J. Guttilla August 26, 2004 State tax administrators do not like to resort to litigation to enforce their corporate income tax laws. There are too many uncertainties and delays. Further, even when they win a significant court case, they know that other taxpayers will often reshape their plans to avoid making the same operational mistakes that caused the litigant to lose. In an attempt to avoid the courtroom, several east coast states have adopted anti-pic (i.e., anti-passiveinvestment-company) laws during the past year s legislative sessions. None of the legislation would have been necessary if these states had changed from separate-company reporting to require combined or unitary reporting. Combined or unitary returns automatically nullify the tax advantage of using PICs to manage and license intellectual property or to centralize intercompany lending. But these states, like most in the eastern United States, have long-standing traditions of separate-company tax reporting. Lawmakers in those states fear the budgetary uncertainty involved with changing a separate-company system to a unitary system. They just can t reliably predict whether their revenue would be increased or reduced. So, all things considered, it s safer for them to merely tinker with their separate-company reporting systems, attempting to outlaw widespread tax planning strategies like the use of PICs. Massachusetts, Maryland, Virginia, and the District of Columbia have all adopted laws this year, modeled after the one implemented during the previous year by New Jersey. For most corporate taxpayers, these new laws will eliminate the motivation to use PICs. But there may still be some planning opportunities and some means of challenging these laws. 1 This term refers to a passive investment company ( PIC ) which generates intercompany interest or royalty deductions in separate-return states. Most companies headquartered in the eastern U.S. tend to create their PICs in Delaware, which offers them an income tax exemption in 1902(b)(8) of its tax law. Western-state companies tend to set up their PICs in Nevada, which has no corporate income tax. Many other companies merely house their PICs in unitary states in which they already file returns, since the PIC will generate no additional tax cost in that state. 1 of 7

2 The New Jersey Model The New Jersey legislature adopted Rev. Stat. 54:10A-4.4 in July 2002, retroactive for all tax years beginning in or after January Regulations were published in February 2003, providing examples with answers to some of the more common questions. N.J. Admin. Code 18: The New Jersey law disallows any deduction for interest or royalties paid to a related member of a combined group, unless the taxpayer establishes that the recipient had incurred a bona fide external cost in order to generate the income, and establishes that tax avoidance was not a principal purpose of the intercompany transaction. The procedural genius of the New Jersey law is that it reverses the traditional burden of proof, forcing any taxpayer who claims that its PIC is something other than a tax-planning strategy, to prove it. All intercompany interest and royalty deductions are disallowed, except for those that satisfy narrow safe-harbor definitions. And even those are only deductible if the taxpayer establishes, by a preponderance of the evidence, that the related party had borrowed the funds or licensed the intellectual property from a third party, and that the PIC transaction does not have as a principal purpose the avoidance of New Jersey tax. This was legislation that dealt only with New Jersey tax returns already being filed, so no company could claim that the state was exceeding the reach permitted by the constitutional nexus concept. Further, the law includes an omnibus clause that permits any taxpayer to establish, by clear and convincing evidence 2 as determined by the director, that the disallowance is unreasonable. This permits state officials to make taxpayer-friendly public statements, assuring businesses that the law will be applied in a reasonable fashion. The expectation, of course, is that no company whose PIC provides a New Jersey tax savings will attempt to convince the director that the disallowance of its deductions is unreasonable. Despite its genius, one of the safe harbors in the New Jersey legislation might offer the key to the proper use of PICs in the twenty-first century. It provides that one may still deduct interest or royalties if they are directly or indirectly paid, accrued or incurred to a related member in a foreign nation which has in force a comprehensive income tax treaty with the United States. Rev. Stat. 54:10A-4.4(b)(1)(a). With a little diligent treaty-shopping, the motivated tax planner should be able to find an offshore jurisdiction with a tax environment hospitable to a PIC. And, as international tax planners have long been aware, there is an entire industry of nexus providers in many tax-haven jurisdictions which will undoubtedly provide the same services as have routinely been available in Wilmington and Reno. 2 Traditionally, the clear and convincing standard for a burden of proof stands somewhere between the criminal law standard of beyond a reasonable doubt and the more common tax law standards of by a preponderance of the evidence or more likely than not. Massachusetts Technical Information Release No , 9/04/03 provides guidance for its interpretation of the term originally used in the New Jersey legislation, stating: Clear and convincing evidence is evidence that is so clear, direct and weighty that it will permit the Commissioner to come to a clear conviction, without hesitancy of the validity of the taxpayer s claim. 2 of 7

3 Massachusetts Cloned the New Jersey Statute The Massachusetts legislators must have really admired the work of their New Jersey brethren. In March 2003, they adopted a nearly identical statute, also making it retroactive to years beginning on or after January 1, The only difference between the New Jersey language and the Massachusetts language is that Massachusetts did not adopt the treaty-county safe harbor provision. This may open a different planning opportunity for offshore PICs. The very issue that prompted New Jersey to include the treaty-county provision may be the Achilles heel of the Massachusetts statute. Arguably, the Massachusetts law will violate the Foreign Commerce Clause of the U.S. Constitution 3 by failing to offer full deductibility of intercompany payments to the U.S. affiliates of foreign companies. The U.S. Supreme Court decision in Japan Line, Ltd. v. County of Los Angeles, 441 U.S. 43 (1979), added two requirements to the traditional Commerce Clause analysis when foreign commerce was involved. It held that a state tax would be unconstitutional if it either created an enhanced risk of multiple taxation or adversely affected the federal government s ability to speak with one voice when regulating commercial relations with foreign governments. Maryland s Anti-PIC Law Refers to the Other States Effective Tax Rate Maryland tried a different approach to disallow the PIC tax benefit. Md. Code Ann. Tax- General was enacted and effective on July 1, 2004, and is applied retroactively to all tax years beginning after December 31, It has the same presumption of disallowance used in both New Jersey and Massachusetts. However, unlike the safe harbors adopted in those two states, Maryland s safe harbors require an examination of how the recipient-related party is taxed on the interest or royalty payment being deducted in Maryland. The effect is to provide a safe harbor for payments to related parties only if: the related party is subject to another state s income tax at a rate of at least four percent (4%), or the payor and the related-party payee of interest are both banks. In cases where a corporation believes its PIC has real economic substance as a separate business entity 4 and can demonstrate a bona fide business purpose other than tax avoidance, it should not hesitate to continue to deduct related-party interest or royalties in Maryland. If challenged by the comptroller, two legal theories are available to contest the interest disallowance, and one of those theories will also provide a sound basis to contest the royalty disallowance. Both the interest and the royalty disallowance rules appear on their face to violate the Commerce Clause of the U.S. Constitution. 5 The concepts of fair apportionment and 3 The Congress shall have Power...To regulate commerce with foreign nations, and among the several States, and with the Indian tribes. US Const. Art. I, 8, Cl 3. 4 This test was applied by the Maryland Court of Appeals in Comptroller Of The Treasury v. SYL, Inc., 375 Md A2d 399 (2003). 5 Note 4, supra. 3 of 7

4 reasonable relation to the income earned within the state have traditionally been viewed as requiring each state to tax no more than its fair share of a corporation s business income. This fair share ought to be susceptible of computation on the basis of activity within the state. There should be no need to introduce an examination of whether another state imposes a tax on this taxpayer, or on any related party engaging in an intercompany transaction. However, the Maryland disallowance provision would appear to disallow a deduction for interest or royalties paid to a Delaware or Nevada PIC, but would permit the deduction if the PIC was operated in a unitary state and subject to state income tax. The Maryland interest disallowance provision would also seem to be vulnerable to a claim that it violates the Equal Protection Clause of the Fourteenth Amendment to the U.S. Constitution, which provides: nor shall any State... deny to any person within its jurisdiction the equal protection of the laws. 6 This clause prohibits a state from enacting arbitrary or irrational classifications and distinctions into its taxing statutes. Some latitude is permitted to achieve legitimate taxing objectives. However, it is hard to imagine that banks are the only entities whose use of interest-pics is per se an appropriate tax planning strategy. Maryland s Amnesty Legislation The Maryland comptroller offered a limited amnesty to PIC users last year, immediately after the SYL decision was announced by the Court of Appeals. Unfortunately, his terms were not very inviting, and it is reported that only fourteen taxpayers came forward, confessed their PIC sins, and made the amnesty deal. So the legislature has made another offer of partial amnesty to elicit taxpayers to address prior years PIC usage. The new settlement period program is only available for four months, from July through October L. 2004, c. 557, 1, effective Any out-of-state PIC that now confesses that it owes Maryland tax due to the SYL decision will be relieved of all pre-1995 tax liabilities, in exchange for settling up all tax and interest for 1995 through Interest is capped at 6.5 percent, and all penalties are waived. Perhaps the most unusual feature of this settlement period is that the taxpayer has the choice of resolving these years in either of two ways: all otherwise deductible payments must be added back to the return of the Maryland taxpayer that deducted them; or the receiving taxpayer must file a Maryland income tax return. A myriad of strategic questions and aggressive interpretations are raised by this election, and several out-of-state corporations are actively considering coming forward. However, to date, the only corporations that have taken advantage of the settlement period are those whose cases were already docketed in the Maryland Tax Court pending the resolution of SYL. 6 U.S. Const. amend. XIV, 1. 4 of 7

5 Virginia Combines the Best (and the Worst) of Everyone Else s Virginia was the next of the states to act, adopting its provision during the just-completed summer 2004 legislative term. The new provisions, codified as Va. Code Ann (b)(8) and (b)(9), put into different words the essential concepts embodied in the New Jersey statute, including its treaty-county safe harbor provision. It also borrows from the Maryland formulation the safe harbor for any transaction in which the related member is subject to a state income tax on the interest or royalty income. Virginia s provision is more liberal than Maryland s, merely requiring the income to be subject to tax but not specifying any required effective tax rate such as Maryland s required four percent. Thus, Virginia has enacted a statute which is vulnerable to all the offshore avoidance of New Jersey s, and subject to the same constitutional challenges as Massachusetts s and Maryland s. The Virginia statutes take a slightly different approach to defining the safe harbors from which PICs may still function. Instead of relying on the tax commissioner and the courts to determine when there is economic substance to a PIC, the legislature has provided a pair of bright-line tests. In order to deduct intercompany interest payments, the recipient of the interest must be an entity that has substantial business operations relating to interest-generating activities, in which the related member pays expenses for at least five full-time employees who maintain, manage, defend or are otherwise responsible for operations or administration relating to the interest-generating activities.... And in one of the safe harbors for intercompany royalties, the recipient must be an entity that derives at least one-third of its gross revenues from the licensing of intangible property to parties who are not related members, and the transaction giving rise to the expenses and costs between the corporation and the related member was made at rates and terms comparable to the rates and terms of agreements that the related member has entered into with parties who are not related members for the licensing of intangible property. In its procedural rules, the Virginia statute also adds a provision guaranteed to warm the hearts of tax lawyers throughout the Commonwealth. It provides considerable discretion to the tax commissioner to make findings of who qualifies for the safe harbors, and then states: Id. No suit for the purpose of contesting any action of the Tax Commissioner under this subdivision shall be maintained in any court of this Commonwealth. In other words, the tax commissioner s decision is final and non-appealable. This remarkable provision will assuredly confer federal court jurisdiction on any taxpayer who is unhappy with the tax commissioner s decision. In general, state tax disputes cannot be resolved by the federal courts due to the federal Anti-Injunction Act, which states: 5 of 7

6 The district courts shall not enjoin, suspend or restrain the assessment, levy or collection of any tax under State law where a plain, speedy and efficient remedy may be had in the courts of such State. 28 U.S.C It seems unlikely that the Virginia General Assembly would have intentionally divested the Commonwealth s circuit courts of jurisdiction to hear appeals of the anti-pic legislation, knowing that this opened the door to the federal district courts. However, that may be exactly the effect of this provision. D.C. Moves Against Royalty PICs, Ignoring Interest PICs Surprisingly, the D.C. Council took action on August 2, 2004, adopting both the Corporate Income Tax Base Protection Emergency Act of 2004, and the Corporate Income Tax Base Protection Act of D.C. suffers from the considerable disability of requiring congressional approval of any change in its laws other than emergency changes. Emergency legislation may only be in effect for ninety days from the date of the mayor s signature, and permanent legislation must ripen for thirty legislative days (i.e., days when Congress is in session) before it can become effective. The emergency bill is effective for ninety days starting August 2, No one can say when the permanent bill will become effective or whether there will be a gap between the coverage of the emergency and the permanent bills. However, in an election year it is possible that Congress will not satisfy the thirty-legislative-day requirement until after Election Day. Further, neither of the bills indicates to which tax years it applies. In view of such silence, legislation is normally presumed to be effective for all open years. It will be interesting to see how the D.C. Office of Tax and Revenue applies this power. The new laws use the general New Jersey formula to disallow intercompany royalty expenses, and include the same treaty-country safe harbor provision. Like the Maryland law, they also include a reference to whether the receiving company is subject to state taxation elsewhere, but using a 4.5 percent rate as opposed to Maryland s four percent. (The locals know that everything is a little less expensive in Maryland!) For some reason not stated, the D.C. Council chose to adopt the anti-royalty provision but not an anti-interest provision. 7 D.C. Acts of Council # and , respectively. 6 of 7

7 If you have any questions or require further information, please call your regular Nixon Peabody contact or feel free to contact one of the attorneys listed below: In our San Francisco office, Mark M. Foster ( ) or In our Washington, D.C. office, Kenneth H. Silverberg ( ) or In our Washington, D.C. office, Christian McBurney ( ) or In our Rochester office, Scott F. Cristman ( or In our Boston, MA. office, Nicholas J. Guttilla ( ) or If you are not currently on our mailing list and would like to receive future publications of our State and Local Tax Advisor, please send your contact information, including address, to 7 of 7