Alabama Circuit Court Invalidates Add-Back of Royalties Paid to Affiliates

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1 State Tax Alert January 2007 No. 1 Alabama Circuit Court Invalidates Add-Back of Royalties Paid to Affiliates The first decision in the nation to analyze a statute that requires the add-back of royalties paid to an affiliate found that Alabama s add-back statute did not require the taxpayer to add-back royalties it paid to two Delaware Holding Company affiliates. While many states have adopted add-back statutes over the last several years that either require a taxpayer to add-back royalty and/or interest paid to an affiliate or deny the deduction of such expenses, VFJ Ventures is the first published decision addressing the validity of an add-back statute. On January 24, 2007, Alabama s Circuit Court of Montgomery County held that an Alabama taxpayer was not required to add-back royalties it paid to two affiliates (see attached decision in VFJ Ventures, Inc. v. Alabama Department of Revenue, No. CV ). Alabama s statute provides that: For purposes of computing its taxable income, a corporation shall add back otherwise deductible interest expenses and costs and intangible expenses and costs directly or indirectly paid, accrued or incurred to, or in connection directly or indirectly with one or more direct or indirect transactions, with one or more related members. Ala. Code (b)(1). A corporation can avoid the add-back by proving that the adjustments are unreasonable. Ala. Code (b). In this case, the Department of Revenue issued an assessment against VFJ Ventures, asserting that it should add-back approximately $100,000,000 of royalty payments it made in 2001 to two related entities, each of which was a Delaware Holding Company. The taxpayer contested the assessment and argued that the two related entities had business purpose and economic substance. In addition, the related entities had 3,200 square feet of office space in Delaware, and employed at least fifteen individuals, including trademark attorneys and staff. The Montgomery County Circuit Court determined that the royalty payments are not abusive and represent real and necessary costs of doing business in Alabama. Thus, it concluded that the add-back of the royalty payments was unreasonable because the disallowance of these deductions would distort the amount of income fairly attributable to the state. Because the court invalidated the Department s assessment on statutory grounds, it did not address whether Alabama s add-back statute passed Commerce Clause muster. 2007, BLANK ROME LLP. Notice: The purpose of this newsletter is to review the latest developments which are of interest to clients of Blank Rome LLP. The information contained herein is abridged from legislation, court decisions, and administrative rulings and should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel. One Logan Square Philadelphia, Pennsylvania

2 STATE TAX ALERT accordance with a statute similar to Alabama it should consider filing refund claims prior to the expiration of the next statute of limitations. If you have any questions regarding this decision by the Alabama Circuit Court or would like to discuss the specific options available for your company, please call Mike Semes, Dave Kuchinos, or Rob Harrill. Business Tax Group Joseph T. Gulant, Practice Chair jgulant@blankrome.com Many states have enacted statutes similar to Alabama. For instance, in New Jersey, a taxpayer can avoid that state s add-back requirement if it establishes by clear and convincing evidence, as determined by the director, that the adjustments are unreasonable. N.J. Rev. Stat. 54:10A-4.4(c)(1)(b). Likewise, a corporation can avoid Ohio s add-back if it establishes by Office Locations clear and convincing evidence that the adjustments are unreasonable. Ohio Rev. Code Ann Blank Rome Observation. In light of this decision, taxpayers should examine their current filing posture in states that require the add-back of interest and royalty expenses paid to related entities. If a taxpayer added-back affiliate expenses on its original return in 1200 North Federal Highway Suite 417 Boca Raton, FL Lake Drive East Woodland Falls Corporate Park Suite 200 Cherry Hill, NJ East Fifth Street 1700 PNC Center Cincinnati, OH The Chrysler Building 405 Lexington Avenue New York, NY One Logan Square 130 North 18th Street Philadelphia, PA Robert M. Broder broder@blankrome.com Robert P. Harrill Jr harrill@blankrome.com Cory G. Jacobs jacobs-c@blankrome.com David M. Kuchinos kuchinos@blankrome.com Harry T. Lamb lamb@blankrome.com Harold N. Pappas hpappas@blankrome.com Jessica S. Powers powers-j@blankrome.com Michael J. Semes semes@blankrome.com Barry E. Sweet sweet@blankrome.com Gregg W. Winter winter@blankrome.com 200 West State Street Trenton, NJ Watergate 600 New Hampshire Avenue NW Washington, DC Chase Manhattan Centre 1201 Market Street Suite 800 Wilmington, DE Suite 1303 Dina House, Ruttonjee Centre 11 Duddell Street, Central Hong Kong To be added to or removed from any or all Blank Rome notices, please call extension 4493 or update@blankrome.com BLANK ROME LLP 2

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