State & Local Tax Alert

Transcription

1 State & Local Tax Alert Breaking state and local tax developments from Grant Thornton LLP Indiana Tax Court Finds Department Erred in Reclassifying Gain from Sale of Subsidiary as Business Income On July 11, 2017, the Indiana Tax Court held that the Indiana Department of Revenue erred in reclassifying a corporation s gain on a 2001 sale of a subsidiary from nonbusiness income to business income. 1 The Tax Court also addressed the scope of the Department s authority to make adjustments to net operating losses (NOLs) in closed tax years, holding that a calculation of a carryover credit from a closed year can be revisited only to determine the tax liability for an open year. Background E.I. DuPont De Nemours and Company ( DuPont ), a Delaware corporation, and Merck & Co., Inc., formed the DuPont Merck Pharmaceutical Company ( DMPC ) in In 1998, Merck sold its interest in DMPC to DuPont Pharma, Inc., a subsidiary of DuPont, at which point DMPC was renamed DuPont Pharmaceuticals Company ( DPC ). Both DMPC and DPC operated independently of DuPont. DuPont sold DPC in 2001 in a transaction that resulted in a gain to DuPont of over $4 billion. In addition to the business arrangement with Merck, DuPont was engaged in several lending arrangements with its own subsidiaries. DuPont Energy Company ( DEC ), a subsidiary of DuPont, loaned DuPont approximately $8 billion in 1995 (1995 Loan). Under the terms of the loan, DuPont was not required to make any payments on interest or principal until In 1998, the promissory note associated with the 1995 Loan was assigned to DuPont Global Operations, Inc. ( DGOI ), also a DuPont subsidiary. In 1999, DGOI loaned DuPont $3.9 billion (1999 Loan). The terms of this note also did not require DuPont to make any payments on interest or principal until On the same day the 1995 Loan became due, August 31, 2005, DGOI loaned DuPont an amount equal to the full value of the principal and the total interest due on the 1995 Loan (2005 Loan). The terms of the 2005 Loan did not require DuPont to make any payments on the principal or the interest for 10 years. Release date July 27, 2017 States Indiana Issue/Topic Corporate Income Tax Contact details Geoffrey Frazier Cincinnati T E geoff.frazier@us.gt.com Jamie C. Yesnowitz Washington, DC T E jamie.yesnowitz@us.gt.com Chuck Jones Chicago T E chuck.jones@us.gt.com Lori Stolly Cincinnati T E lori.stolly@us.gt.com Priya D. Nair Washington, DC T E priya.nair@us.gt.com In 2009, the Department audited DuPont s 2005, 2006, and 2007 consolidated Indiana adjusted gross income tax ( AGIT ) returns and: (i) reclassified the gain DuPont received from the sale of DPC as apportionable business income which substantially increased 1 E.I. DuPont De Nemours and Co. v. Indiana Department of State Revenue, Indiana Tax Court, No. 49T TA-00065, July 11,

2 Grant Thornton LLP - 2 DuPont s 2001 adjusted gross income and reduced NOLs available for use in subsequent tax years; (ii) eliminated the interest expense deductions DuPont reported during the audit period that were related to the 1995, 1999, and 2005 Loans; and (iii) eliminated DuPont s 2007 research and development (R&D) expense deduction. The Department issued proposed assessments for additional AGIT and interest for the 2006 and 2007 tax years and a penalty for DuPont protested the proposed assessments, which the Department denied in a letter of findings. DuPont appealed, asserting that the audit adjustments were improper. Subsequent cross-motions for summary judgment raised four issues: (i) the Department s authority to make NOL adjustments in closed tax years; (ii) the proper classification of the gain on the sale of DPC; (iii) the disallowance of DuPont s interest expense deductions; and (iv) the disallowance of DuPont s R&D expense deductions. Retroactive Adjustments The proposed assessments arose, in part, from reductions the Department made to NOLs reported on DuPont s pre-2005 tax returns. These reductions lowered NOL carryforwards that DuPont could deduct on its 2006 and 2007 returns. DuPont s NOL was originally incurred in 2001 and had a 20-year carryforward period. DuPont argued that the Department could not make retroactive adjustments to its pre-2005 tax years because these tax years fell outside the statute of limitations and thus were closed years. The Tax Court rejected this argument on multiple grounds and held that the calculation of... [a] carryover credit from... [a] closed year [may be revisited] only for the purpose of determining the tax liability for the open year. 2 In reaching its holding, the Tax Court noted that, because the accuracy of the 2005, 2006, and 2007 NOL deductions depended on the accuracy of the original 2001 NOL calculation, the Department had the power and a duty to examine the 2001 NOL calculation. The Tax Court also noted that, while state law 3 prohibits a proposed assessment against a taxpayer more than the later of three years after the date its return is either filed or due, it does not set time limits on adjustments to tax returns. Furthermore, DuPont failed to identify any statutory authority that would prohibit the Department from making adjustments to closed years. The Tax Court also rejected DuPont s argument that retroactive taxes do not promote certainty... and settled expectations, noting that these concerns do not come into play in this case because DuPont was afforded closure and certainty. Specifically, while the Department can correct an error in a closed year, the assessment of additional tax is governed by strict statutory limits. Reclassification of Gain as Business Income Turning to the issue of DuPont s gain from the 2001 sale of DPC, the Tax Court held that the Department improperly reclassified the gain as business income. During the audit period, business income was defined as income arising from transactions and activity in the regular course of the taxpayer s trade or business and includes income from tangible and intangible property if the acquisition, management, and 2 Citing to Hillenga v. Department of Revenue, 361 P.3d 598 (Or. 2015). 3 IND. CODE (a).

3 Grant Thornton LLP - 3 disposition of the property constitutes integral parts of the taxpayer s regular trade or business operations. 4 Nonbusiness income is defined as all income other than business income. 5 Two tests, the transactional test and the functional test, were used to determine whether income would be characterized as business income. Transactional Test Under the transactional test, business income is income arising from transactions and activities in the regular course of the taxpayer s trade or business. Applying this test, the Tax Court concluded that the gain from the sale of DPC did not constitute business income because the sale did not occur in the regular course of DuPont s trade or business. Specifically, DuPont s regular business was that of industrial, agricultural, and chemical manufacturing, not the sale of its subsidiaries. The Tax Court refused to infer, as the Department requested, that DuPont s regular trade or business was buying and selling other businesses based on the annual fluctuation in the number of subsidiaries DuPont owned and language in the company s articles of incorporation providing that it may purchase, sell, develop, and operate lands and buildings. Functional Test Under the functional test, the gain from the disposition of a capital asset is business income if the asset was acquired, managed, and disposed of by a taxpayer in its regular trade or business operations, irrespective of the extraordinary nature or infrequency of the sale. While the Tax Court conceded that DuPont may have acquired and disposed of DPC as an integral part of its manufacturing business, 6 it noted that, under the functional test, in order to characterize the gain as business income, DuPont must have also managed DPC as an integral part of its manufacturing business. The Tax Court noted that there was no evidence that DuPont played a role in the management of DPC. 7 As a result, the gain from the sale of DPC failed to constitute business income under the functional test. Unitary Business The Tax Court also noted that the same result would be achieved under the U.S. Constitution s unitary business principle standard, which allows a state to tax an apportioned portion of a corporation s multistate business if the business is unitary. A finding of a unitary business relationship between DuPont and DPC requires a showing of functional integration, central management, and economies of scale. The Tax Court found the absence of all three factors. Specifically, the Tax Court noted that there was no flow of value between DuPont and DPC, DuPont exercised limited oversight over DPC, and economies of scale between DuPont and DPC (for example, through the sharing of 4 IND. CODE The current definition of business income includes all income that is apportionable to the state under the Constitution of the United States. 5 IND. CODE The Department argued, in part, that DuPont s public filings indicated that DPC was integral to its business. 7 The Tax Court noted that like its predecessor DMPC, DPC maintained its own management team, its own research agenda and development facilities, its own employees, its own profit objectives, and its own operating policies and procedures.

4 Grant Thornton LLP - 4 centralized purchasing) did not exist. Therefore, DuPont s gain on its sale of DPC did not constitute apportionable business income. Disallowance of Intercompany Interest Deductions The Department disallowed nearly $3.1 billion in interest expense deductions claimed by DuPont, finding that the underlying loans lacked economic substance and were therefore sham transactions. 8 In order to determine whether a transaction lacks economic substance, the Tax Court applied the federal economic substance doctrine which requires the application of two separate tests: (i) a business purpose test, which looks to whether the taxpayer was motivated by any business purpose other than obtaining a tax benefit; and (ii) the economic substance test, which looks to whether a reasonable possibility of a profit existed. The Department argued that the loans failed both tests because the loans were never repaid and their sole effect was to wipe out DuPont s Indiana income through the interest expense deductions. The Tax Court quickly rejected the Department s argument that the loans lacked business purpose, noting that the transactions with DEC and DGOI were part of a larger restructuring plan to raise additional capital through a public stock offering. The Tax Court also rejected the Department s argument that the loan transactions lacked economic substance because they were structured without a profit motive. Specifically, the Department had argued that: (i) DGOI had no receipts, sales, or income by which it could have made its multi-billion dollar loans to DuPont; (ii) DuPont never made any payments on the loans; and (iii) the loans carried interest rates that were too high. The Tax Court disagreed on all three counts. The Court noted that DEC and DGOI were sufficiently funded and able to loan money to DuPont. Further, the interest expense and corresponding interest income on the loans were accrued on each party s financial statements, so that DuPont treated the loan as if payments were made on the loans. Finally, DuPont proved that the interest rates were not too high, by producing evidence showing that the interest rates on the loans were within the IRC Sec. 482 safe haven range, and DuPont would not have been able to refinance the loans at lower rates. 9 Disallowance of R&D Expense Deductions DuPont had the option of taking either a deduction or a credit for its R&D expenses on its 2007 federal income tax return, and it chose to take the credit. However, on its 2007 Indiana AGIT return, DuPont deducted its R&D expenses, which the Department disallowed on audit. The Tax Court upheld this disallowance, noting that Indiana only allows an R&D credit, not a state R&D expense deduction. 8 For tax years beginning before January 1, 2016, under IND. CODE (b)(2), taxpayers were only required to add back intercompany interest if it represented directly related intangible interest expenses. The law was amended to broaden the required addback to all directly related interest expenses. Accordingly, all intercompany interest is subject to addback for years beginning on or after January 1, 2016 unless it meets one of the exceptions in IND. CODE (c). 9 The Tax Court has previously relied on the use of IRC 482 to determine whether intercompany charges are appropriate prior to allowing the Department to use its discretionary authority to make adjustments to income. Columbia Sportswear USA Corp. v. Indiana Department of State Revenue, 45 N.E.3d 888 (Ind. Tax Ct. 2015). For a discussion of this case, see GT SALT Alert: Indiana Tax Court Rules Transfer Pricing Studies Should Be Respected When Determining Indiana Income.

5 Grant Thornton LLP - 5 The Tax Court explained that the starting place for reporting adjusted gross income on an Indiana AGIT return is federal taxable income. If DuPont had elected to take a deduction for its R&D expenses, its federal taxable income would have reflected, and benefitted from, this deduction. Notwithstanding that Indiana does not allow for a state R&D expense deduction, DuPont deducted its R&D expenses from taxable income reported on its Indiana AGIT return arguing that the R&D expenses should be deductible in calculating its Indiana AGIT base. 10 The Tax Court rejected this argument, pointing out that Indiana law does not provide a specific deduction from the AGIT base for R&D expenses, and that by taking an R&D expense credit at the federal level, DuPont s federal taxable income under IRC Sec. 63 (and consequently its Indiana AGIT base) could not reflect an R&D deduction. The Tax Court waived penalties associated with DuPont s 2007 tax deficiency related to the business/nonbusiness income classification, the interest expense deduction and the R&D expense deduction issues. DuPont was able to successfully show that the tax deficiencies associated with these issues were incurred due to reasonable cause and not willful neglect. Commentary The Tax Court s decision serves as a reminder to the Department that it must provide concrete evidence to support its business/nonbusiness income determinations. The Tax Court s analysis of the business/nonbusiness income issue provides insight that a court will not automatically lean towards a finding of business income. For example, the Tax Court refused to infer that DuPont s regular trade or business is buying and selling other businesses based on the relatively scant evidence advanced by the Department. Taxpayers selling subsidiaries that have been operated on an autonomous basis may consider whether proceeds from those transactions should be treated as business or nonbusiness income. This decision is also notable for its holding on the treatment of NOLs in closed years, which appears to have been one of first impression in Indiana. The Tax Court cited to an Oregon Supreme Court decision, Hillenga v. Department of Revenue, for the proposition that [a] taxpayer who seeks to apply a carryover from a closed year against the income from an open one actively puts the carryover from the closed year in issue. The Tax Court s endorsement of DuPont s loan arrangements with its subsidiaries is somewhat surprising, given that no actual principal or interest payments on the loans were ever made. While the business purpose of the transactions was relatively clear and in line with a view towards restructuring, the satisfaction of the economic substance test required that the Tax Court accept accruals of interest as valid substitutes for actual physical transfers of money. The Tax Court reached that result by relying on a financial accounting principle that treats accruals as if actual cash has been exchanged. 10 Citing to Cooper Indus. v. Indiana Department of State Revenue, 673 N.E.2d 1209 (Ind. Tax Ct. 1996), for the proposition that Indiana adjusted income begins with federal taxable income as defined by I.R.C. 63, not as reported by the taxpayer. Thus, the issue is not what number appears on line 28 of a taxpayer s federal income tax form 1120 but whether a particular item of income was included in taxable income pursuant to I.R.C. 63.

6 Grant Thornton LLP - 6 Finally, the Tax Court s willingness to waive penalties associated with DuPont s reading of state law for purposes of the R&D expense deduction is a positive development. Although DuPont s attempt to take the R&D expense deduction may have been aggressive, the Tax Court nonetheless held that DuPont s interpretation of taxable income that led to its R&D expense deduction was not unreasonable. The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific circumstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying or using any information storage and retrieval system without written permission from Grant Thornton LLP. This document supports the marketing of professional services by Grant Thornton LLP. It is not written tax advice directed at the particular facts and circumstances of any person. Persons interested in the subject of this document should contact Grant Thornton or their tax advisor to discuss the potential application of this subject matter to their particular facts and circumstances. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed.