State & Local Tax Alert Breaking state and local tax developments from Grant Thornton LLP New Jersey Tax Court Finds Payments Made by Subsidiary Qualify for Exception to Addback Rule On May 24, 2017, the New Jersey Tax Court granted a taxpayer s motion for summary judgment and allowed deductions for royalty payments made by a subsidiary to its parent company. 1 Specifically, the Court found that the payments qualified for the unreasonable exception to the addback rule because they were substantively equivalent to payments made by the subsidiary and/or the parent to unrelated third parties under transactions involving the same subject and object (the sale of prewritten computer software license and service contracts). Background BMC Software, Inc. (Parent), a Delaware company headquartered in Texas, creates and develops computer software programs and markets the software in several states, including New Jersey. In 2002, it entered into a five-year renewable licensing agreement with its wholly-owned subsidiary, BMC Distribution Inc. (Subsidiary), which was primarily engaged in selling and marketing Parent s products. Subsidiary was granted a nonexclusive right to license, market and distribute Parent s prewritten software in approved geographic areas. 2 Under the licensing agreement, Subsidiary paid 55 percent of its gross license and maintenance revenue to Parent as a royalty. 3 Parent retained the right to control all aspects of Subsidiary s business to ensure that the products were being distributed, licensed and marketed in accordance with its policies and procedures. Parent also granted similar licenses to use the software to unrelated third parties. In 2008, Subsidiary merged into Parent, which was the successor taxpayer that was a party to this litigation. On its New Jersey Corporation Business Tax (CBT) returns for fiscal years ending from 2005 to 2008, Parent reported royalty income ranging from approximately $573 million to $780 million. Parent s returns did not specifically identify the royalty amounts received Release date July 7, 2017 States New Jersey Issue/Topic Corporation Business Tax Contact details Frank Schaefer Iselin T 732.516.7658 E frank.schaefer@us.gt.com Bridget McCann Iselin T 732.516.7637 E bridget.mccann@us.gt.com Michael Beck Philadelphia T 215.814.1726 E michael.beck@us.gt.com Guinevere Seaward Arlington T 703.637.4133 E guinevere.seaward@us.gt.com Megan Packett Baltimore T 410.244.3294 E megan.packett@us.gt.com www.grantthornton.com/salt 1 BMC Software, Inc. v. Division of Taxation, New Jersey Tax Court, No. 000403-2012, May 24, 2017. The Court declined to rule on an apportionment issue involving New Jersey s throwout rule, citing insufficient facts. 2 Subsidiary was prohibited from licensing, marketing and distributing the software in 34 specified countries. The licensing agreement included additional specific terms which are noted at length in the decision, including the general terms required between Subsidiary and its customers. 3 The arm s length royalty rate of 55 percent was determined based on a 2002 comparable profits method study conducted by an economic consulting firm. The rate was based on a reasonable profit margin of 2 percent and was similar to the rate paid to Parent by other third-party distributors..
Grant Thornton LLP - 2 from Subsidiary. Except for its fiscal year ending in 2007, Parent reported no receipts from sales of either tangible personal property or services, and only reported amounts received as royalties. For its fiscal year ending in 2007, Parent reported no receipts from royalties and approximately $29 million of receipts from sales of tangible personal property shipped to points within New Jersey. For each year, Parent reported positive income before deductions for net operating losses and/or dividend exclusions. However, the use of net operating losses and dividend income exclusions for those years reduced entire net income (ENI) to $0. For the same years, Subsidiary reported a positive ENI and $0 of cost of goods sold. It deducted amounts ranging from $423 million to $491 million as management fee expenses and reported royalty payments made to Parent ranging from $253 million to $491 million as Types of Intangible Expense Deducted on Schedule G of its CBT return. Further, Subsidiary claimed a portion of the same amounts (ranging from $225 million to $369 million) as falling under an exception to the addback because Parent had included the same amounts in its ENI. Under audit, the New Jersey Division of Taxation disallowed the exception to the addback claimed by Subsidiary for its fiscal years ending from 2005 to 2008, explaining that Parent had not paid CBT on the royalty income because it had $0 in ENI, and therefore did not pay tax on any income. The Division disagreed with the argument that the inclusion of those amounts as royalty income by the Parent required them to be allowed as a business expense deduction to Subsidiary. In turn, the Division issued Parent an assessment of $4,735,253 in CBT for the four fiscal years in question plus penalty and interest, bringing the total assessment to $7,000,281. Parent timely protested the audit findings. Specifically, Parent claimed that Subsidiary should have been entitled to the deduction because it was not licensing intellectual property from Parent, but rather buying prewritten software and then reselling it to endusers. Alternatively, Parent claimed that it was unreasonable for the Division to add back the royalty payments incurred by Subsidiary. Under protest, Parent claimed a refund of $1,241,850. Tax Court Decision This case centered on whether Subsidiary s payments qualified as intangible costs and expenses and, if so, whether the costs qualified for an exception to the addback rule. New Jersey Addback Rule New Jersey s adoption of the Business Tax Reform Act (BTRA) in 2002 represented one of the first efforts by a state to require related-member interest and intangible expenses to be added back in the calculation of taxable income. 4 For purposes of computing its ENI, a taxpayer is generally required to add back certain otherwise deductible intangible expenses and costs directly or indirectly paid, accrued or incurred to one or more related members. 5 4 Business Tax Reform Act (P.L. 2002, c. 40). 5 N.J. REV. STAT. 54:10A-4.4(b). Intangible expenses and costs are defined to include expenses, losses and costs for, related to, or in connection directly or indirectly with the direct or indirect
Grant Thornton LLP - 3 Intangible expenses and costs include royalty, patent, technical and copyright fees; licensing fees; and other similar expenses and costs. 6 Characterization of Related-Party Payments as License of Intellectual Property The first issue considered by the Court was whether the payments from Subsidiary to Parent were actually intangible expenses or payments for the purchase of tangible personal property. Parent cited a Tax Court decision in which the sale of prewritten software to end users who signed a license agreement was determined to be a sale of tangible personal property. 7 In that case, a taxpayer developed and sold computer mailing software programs, which were sold on CD-ROMs and contained a licensing agreement. The Division was able to distinguish that decision as it did not interpret or implicate the addback statute, and the focus of the transaction was the sale by an entity and/or its distributor to an unrelated end user, rather than a related-party transaction. 8 The Court also relied upon the carefully drafted licensing agreements between Parent and Subsidiary to conclude that the transaction between the entities encompassed the transfer of a license, generating royalty income to Parent and producing a concurrent intangible cost/expense to Subsidiary. Importantly, Parent retained full ownership of its intellectual property rights in the computer products and Subsidiary could simply use and possess such intellectual property, and then only within the defined scope and purposes of the agreement. 9 Also, ownership of the software was never transferred to Subsidiary or its end user. The Court rejected an attempt by Parent to characterize the transactions between Parent and Subsidiary as drop shipments. Exception to Addback Rule The statutorily required addback is often a costly adjustment for taxpayers operating multistate and multinational businesses that frequently lend and make transactions across a group of related companies. Thus, legislators allowed taxpayers an opportunity to mitigate the impact if one of several available exceptions are met. 10 In particular, the statute permits the deduction for related-party intangible expenses if a taxpayer meets an unreasonable acquisition, use, maintenance or management, ownership, sale, exchange, or any other disposition of intangible property to the extent such amounts are allowed as deductions or costs in determining taxable income before an operating loss deduction and special deductions for the taxable year under the Internal Revenue Code. N.J. REV. STAT. 54:10A-4.4(a). See also N.J. ADMIN. CODE tit. 18, 7-5.18(b). 6 N.J. REV. STAT. 54:10A-4.4(a). 7 AccuZIP, Inc. v. Director, Division of Taxation, 25 N.J. Tax 158 (2009). Notably, the primary issue was whether the taxpayer had nexus with New Jersey for CBT purposes. 8 The Court also considered the terms of both licensing agreements and found significant differences. 9 Interestingly, although the Forms 10-K filed with the Securities and Exchange Commission (SEC) by Parent indicated that certain unrelated parties which marketed or distributed Parent s products and services were deemed owners after Parent delivered the products to end users, no such language appeared in the licensing agreement between Parent and Subsidiary. 10 N.J. REV. STAT. 54:10A-4.4(c)(1). Available exceptions include the: (i) foreign treaty exception; (ii) unreasonable exception; and (iii) alternative method of apportionment exception.
Grant Thornton LLP - 4 test, where there is clear and convincing evidence, as determined by the Director, that the disallowance is unreasonable. The unreasonable exception was first accepted by the New Jersey Tax Court in Beneficial New Jersey, Inc. v. Director, Division of Taxation. 11 In that initial New Jersey case addressing the statutory exceptions to related-member interest addbacks, the Court allowed a finance company to deduct interest it paid on a loan from its parent corporation. The determination was based in part on the ordinary and well-understood meaning of the term unreasonable, which was undefined in the statute. Although not included in the statute, based on related regulations, a taxpayer is permitted to deduct intangible expenses if it can show that the recipient of the payment pays tax to New Jersey on the income stream. 12 Schedule G-1 of the CBT return notes that an exception to the addback is allowed if the intangible expenses and costs were directly or indirectly paid, accrued or incurred to a related member that is a corporation that files a [CBT] return... and such member has included those amounts in its entire net income. 13 Accordingly, this is a discretionary exception to prevent the double payment of tax. If, however, the related member s tax liability was not greater than the statutory minimum tax, then the taxpayer is not entitled to the deduction (i.e., the addback will be required). 14 Because Parent paid no actual CBT, Subsidiary was not eligible for this exception. Thus, the Court considered whether the use of losses to offset income, resulting in a minimum CBT return, necessarily prohibits a taxpayer from proving that the addback (or disallowance of a deduction) would be unreasonable. Specifically, the Court relied upon the decision in Morgan Stanley & Co. v. Division of Taxation to support its finding that it does not. 15 The Court found compelling that the related-party interest addback statute at issue in that case allows a deduction if, among other requirements, the related member was subject to tax on its net income or receipts in any state including New Jersey, and a measure of the tax includes the interest received from the related member. 16 Although the unreasonable exception language in the interest expense addback statute is identical to the language in the intangible expense statute, the intangible expense statute has no similar requirement that the related member be subject to tax. 17 Finally, the Court considered whether the unreasonable exception appropriately applied to the addback in the instant case. Specifically, it agreed with Parent that the license agreement between Parent and Subsidiary was similar to license agreements made with unrelated parties and the payments were substantively equivalent to payments made by 11 New Jersey Tax Court, Dkt. No. 009886-2007, Aug. 31, 2010. 12 N.J. ADMIN. CODE tit. 18, 7-5.18(b)(3). 13 Citing to New Jersey Corporation Business Tax Return, Schedule G-1. 14 Id. 15 28 N.J. Tax 197 (2014). The Tax Court held that the inclusion of interest income in the return, and the offset of the same by losses (resulting in the payment of minimum tax) did not satisfy the subject to tax prong of the statute excepting related-party interest from being added back. 16 N.J. REV. STAT. 54:10A-4(k)(2)(I). 17 The Court considered the legislative intent of the BTRA to close loopholes, but continue to allow deductions where no tax avoidance was present. Also, the legislature could have provided that the addback of intangible expenses should be after the deduction for NOLs to prevent this result.
Grant Thornton LLP - 5 either the parent or the subsidiary to unrelated third parties under transactions involving the same subject and object. 18 The licensing agreement with Subsidiary was similar to the third party licensing agreements because both agreements were for the same software license and maintenance service, and had the same object ( i.e., to market, distribute, sublicense, and sell computer products and services to end users). Further, both Parent and Subsidiary (when in existence) were active businesses; neither was a shell entity with no business operations other than passively holding an intangible asset, or with no business purposes other than to receive income, or expense intangible costs and divert income to or from related members. Thus, the Court concluded that Subsidiary s payments to Parent qualified for an exception to the addback rule. Commentary Although this ruling is limited to the facts presented, it does provide additional guidance regarding how intercompany licensing transactions will be scrutinized by the New Jersey Tax Court. Parent and Division both provided well-developed arguments and substantial documentation, allowing the Court to fully examine the transaction. Specifically, the Court focused on the terms of the licensing agreement and the specific circumstances surrounding the transaction, including dealings by the Parent and/or Subsidiary with third parties on similar terms. The Court s substantive analysis shows a practical application that avoids a bright-line rule, instead opting for a fact-specific assessment that seemingly provides more flexibility for taxpayers. It will be interesting to see whether courts in other jurisdictions adopt similar analyses. Additionally, this case provides assurance that the Division will consider unreasonableness on a case-by-case basis, and also provides some precedent to analyze when considering whether adding back intercompany payments may be unreasonable under New Jersey law. It should be noted that the Division has released a regulation, 19 a Technical Advisory Memorandum (TAM) 20 and a Manual of Audit Procedures (MAP) 21 that address certain applications of the related-party addback. The regulation and the TAM go into significant detail with respect to how the Division interprets the related-party addback rules. The TAM outlines certain situations in which the Division will recognize the unreasonableness exception. 22 The MAP directs an auditor to verify that interest and intangible expenses and costs paid, accrued or incurred to related members are added back unless an exception applies, and confirms that the addback includes expenses related to factoring activities conducted with a related party. 23 18 The Court rejected several other arguments asserted by Parent as to why the addback should not apply by reason of the unreasonable exception. Also, the Court rejected several counter-arguments by the Division, including an assertion that the transfer pricing study was inadequate. 19 N.J. ADMIN. CODE tit. 18, 18 :7-5.18. The regulation was recently amended to incorporate the effect of the Morgan Stanley case. 20 Technical Advisory Memorandum 2011-13(R), New Jersey Division of Taxation, issued Feb. 24, 2016. 21 New Jersey Manual of Audit Procedures, New Jersey Division of Taxation, issued March 7, 2017. 22 If this case stands or is upheld on appeal, it will be interesting to see whether the Division will revise this TAM to expand the reach of the unreasonableness exception to the facts of this case. The Division has specifically addressed the Beneficial and Morgan Stanley cases in the TAM. 23 New Jersey Manual of Audit Procedures, 17.15, 21.9.d.
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