The negotiation: Massachusetts controversy

The negotiation: Massachusetts controversy

Disclaimer EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. This presentation is 2015 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party. Views expressed in this presentation are those of the speakers and do not necessarily represent the views of Ernst & Young LLP. This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer s facts and circumstances. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice. Page 2 Sixth Annual Indirect, State and Local Tax Conference Boston 17 March 2015

Today s presenters Representing the Massachusetts Department of Revenue Jason Zorfas Brian Marks Ernst & Young LLP Ernst & Young LLP Boston, MA Boston, MA Representing the Taxpayer, XYZ Widget Dan Lipton Kate Gruber Ernst & Young LLP Ernst & Young LLP Boston, MA Boston, MA Mediator Steven N.J. Wlodychak Ernst & Young LLP Washington, DC Page 3 Sixth Annual Indirect, State and Local Tax Conference Boston 17 March 2015

Background XYZ Widget manufactures and sells widgets. During the 2004 and 2005 tax years, XYZ developed and sold product directly to customers. In 2006, the transferred the intangible property (IP) related to its products from XYZ to B. XYZ continues to perform some research and development (R&D) and performs all headquarter functions. B performs R&D. B is only located in unitary states. In 2007, XYZ terminates the royalty arrangement with B and enters into a buy-sell arrangement with B. Massachusetts audits the for the 2007 and 2008 tax years. The and the Department agree to enter the Early Mediation (EM) Program. Page 4 Sixth Annual Indirect, State and Local Tax Conference Boston 17 March 2015

Massachusetts EM Program EM Program is offered by the Massachusetts Department of Revenue as an option for settling cases ideally settled in one day. EM Program is available when the proposed assessment of tax is in excess of $250,000. Either the Department (usually the audit division) or the taxpayer can request it, but both parties must agree to participate. If that application is accepted by the Commissioner, a date for mediation is scheduled. The process must be completed within a four-month period. The program is not designed to develop facts and therefore shouldn t be used when there are outstanding questions of facts. Both sides must be represented by authorized decision-makers. The mediator is typically an appeals officer at the Department. EM Program is designed for the resolution of legal issues such as economic nexus and apportionment. All issues must be settled as part of the process. Page 5 Sixth Annual Indirect, State and Local Tax Conference Boston 17 March 2015

Issues for consideration at EM Program Issue Amount in dispute Embedded royalties $10m Economic nexus $7m Cash management system $5m Add back of intercompany interest Reclass debt and equity Sham transaction Part of the amounts above 35A penalties $4.4m Page 6 Sixth Annual Indirect, State and Local Tax Conference Boston 17 March 2015

XYZ Widget Tax years: 2004-2005 XYZ Sale to Customer Customer Finance Other operating companies XYZ Develops and manufactures product Sells product directly to customer Has nexus in MA and other states Substantial intercompany liability due to Finance as a result of Cash Management System Intercompany liability continues to grow year after year; XYZ makes no transfers of cash to Finance to settle the intercompany account Finance Operates cash management system Supported by intercompany notes, arm s-length interest rates and transfer pricing study Page 7 Sixth Annual Indirect, State and Local Tax Conference Boston 17 March 2015

XYZ Widget Tax year: 2006 XYZ Sale to Customer Customer Royalty Transfer of IP R&D service Finance B Other operating companies XYZ Transfers IP related to the product to B Continues to perform some R&D on the product (compensated by B via a service fee) and continues to perform headquarter functions for the group Pays a royalty to B for right to market and sell product to customers Continues to sell to customers Continues to have nexus in Massachusetts All intercompany transactions satisfy IRC Sec. 482 requirements and are supported by a transfer pricing study B Performs some R&D Employs legal staff to manage IP Does not have a physical presence in Massachusetts Only has nexus in other unitary states Page 8 Sixth Annual Indirect, State and Local Tax Conference Boston 17 March 2015

XYZ Widget Massachusetts audit Audit period: 2007 and 2008 XYZ Sale to Customer Customer Sale of product R&D service. Finance B Other operating companies XYZ Terminated royalty arrangement with B and has entered into a buy-sell arrangement with B Purchases the product from B Sells product direct to customers at a markup Continues to perform certain R&D services for B All intercompany transactions (including the markup) satisfy IRC Sec. 482 requirements and are supported by a transfer pricing study B Acquires a manufacturing facility located in another unitary state (not Massachusetts), where it manufactures the product Sells product to XYZ as a sale for resale Does not have a physical presence in Massachusetts and only has nexus in other unitary states Page 9 Sixth Annual Indirect, State and Local Tax Conference Boston 17 March 2015

Massachusetts EM Program final observations EM Program settlements are typically based on a dollar amount, i.e., they are not precedential regarding the underlying issues. For EM Program to be successful, both the taxpayer and the Department of Revenue must be willing to make a material concession from their position. If EM Program does not result in a settlement, then the taxpayer may re-enter the traditional appeals process. Under the traditional appeals process, taxpayer may seek a determination and/or settlement. The mediators must destroy all records of the mediation including any taxpayer submissions or offers in settlement, i.e., the appeals officers may not know of or be influenced by the failed EM Program. Page 10 Sixth Annual Indirect, State and Local Tax Conference Boston 17 March 2015

Questions? Page 11 Sixth Annual Indirect, State and Local Tax Conference Boston 17 March 2015

Contacts Jason Zorfas Ernst & Young LLP Boston, MA +1 617 585 3554 jason.zorfas@ey.com Brian Marks Ernst & Young LLP Boston, MA +1 617 375 2408 brian.marks@ey.com Dan Lipton Ernst & Young LLP Boston, MA +1 617 585 1873 daniel.lipton@ey.com Kate Gruber Ernst & Young LLP Boston, MA +1 617 375 2462 kate.gruber@ey.com Steven N.J. Wlodychak Ernst & Young LLP Washington, DC +1 202 327 6988 steven.wlodychak@ey.com Page 12 Sixth Annual Indirect, State and Local Tax Conference Boston 17 March 2015