On September 18, 2012, the New Jersey Division of Taxation (Division) announced that it was offering a limited voluntary disclosure agreement (VDA) initiative for companies that have not filed corporation business tax (CBT) returns but have nexus with New Jersey as a result of deriving income from the use of intangible assets in the state.1 The Division's announcement outlines the parameters of a new, time-sensitive VDA program for intangible holding companies (IHCs) describing the program's duration, lookback period, penalty provisions, treatment of throwout receipts and the prospect of amending CBT returns filed by operating affiliates. While this initiative offers IHCs more favorable terms than in the past, this VDA still does not offer terms as favorable as the terms offered under VDAs by most other states including New Jersey itself (for non-IHCs). Accordingly, companies considering the new program should carefully consider the consequences of their participation.

Overview of Policy Statement

The new program began on September 15, 2012, and runs through January 15, 2013. Participating IHCs must meet the standard conditions for all VDA applicants and should follow the standard procedures for seeking a VDA.2 Additionally, for IHCs the following provisions will apply:

  1. The lookback period will be limited to periods beginning after the later of December 31, 2003, or the date business commenced in New Jersey. Returns for earlier periods will not be required.
  2. The Division will waive all penalties, although a 5 percent post-amnesty penalty will still be assessed for all returns originally due before February 1, 2009.3
  3. The Division will consider discretionary throwout relief by averaging a throwout receipts fraction with a non-throwout receipts fraction. Any settlement as to throwout will be binding on all parties and the taxpayer may not file a claim for refund in the event that the result is affected by a future court decision. If the taxpayer does not wish to settle the throwout issue, the Division will hold the issue for future determination and will conduct an audit on the returns at a later point to make the required determination.
  4. The taxpayer must file all required returns and remit payment of the full tax liability reported within 90 days of execution of the VDA. All interest and penalties must be paid within 30 days of assessment.
  5. Companies that have added back royalties paid to related entities to arrive at New Jersey entire net income may submit amended returns for any period open under the statute of limitations in order to claim an exception to the addback.
  6. Returns are subject to routine audit on issues not specifically covered in the VDA.

Background

Economic Nexus

New Jersey's latest IHC VDA initiative continues the Division's attempts to address the taxation of foreign companies that lack New Jersey physical presence.

In the wake of South Carolina's Geoffrey decision,4 in 1996, the Division added a controversial example to the New Jersey regulation that interprets the phrase "doing business." The example states that a foreign corporation that receives fees for licensing trademarks to New Jersey companies for use in New Jersey is subject to the CBT.5

In 2002, the Business Tax Reform Act ("BTRA") made substantial changes to many sections of the CBT statute. Pursuant to the BTRA, tax is imposed on foreign corporations that derive receipts from sources within New Jersey or engage in contacts within the state if the taxpayer's business activity is sufficient to give New Jersey jurisdiction to impose tax under the United States Constitution.6

Subsequent New Jersey court decisions supported the taxation of foreign corporations without a physical presence in-state. In Lanco, the New Jersey Supreme Court held that the state can subject an out-of-state intangible holding company to CBT even though the company does not have a physical presence in-state.7 In the Court's opinion, the physical presence requirement established in Quill8 is limited to sales and use tax. Instead, the Court followed Geoffrey9 in holding that the act of deriving income from the license of intangibles used in-state is sufficient to establish nexus.

The Lanco decision came at a time when other state courts were reaching similar conclusions10 and was reaffirmed shortly thereafter in Praxair Technology, Inc. v. Director, Division of Taxation.11 In Praxair, the New Jersey Supreme Court upheld the taxation of a taxpayer that entered into a license agreement with its parent to allow the parent to use the taxpayer's intellectual property for a fee, going so far as to permit the Division to tax an IHC during periods preceding the 1996 addition of the aforementioned example to N.J. Admin. Code Sec. 18:7-1.9(b).

Throwout

For tax years beginning on or after January 1, 2002 and before July 1, 2010, New Jersey's "throwout" rule substantially complicates prior period voluntary compliance for IHCs. During such time, the BTRA introduced the throwout rule, which excluded "nowhere" receipts from total everywhere receipts when computing the denominator of the sales fraction. Nowhere receipts resulted from sales made into jurisdictions where the corporation was not subject to tax.12 The throwout rule had the effect of increasing the New Jersey allocation factor and consequently the amount of taxable income sourced and taxed by New Jersey, particularly for IHCs which typically file in a very limited number of jurisdictions.

Although the throwout rule has been repealed, its effect lingers as taxpayers continue to challenge the constitutionality of its application to their specific facts and circumstances. The New Jersey Supreme Court recently affirmed the throwout rule's facial constitutionality under the Due Process Clause and Commerce Clause in the Whirlpool case.13 There, the Court held that the throwout rule did not offend the requisite "minimum connection" and its application produced a result "rationally related" to the taxpayer's connection with New Jersey.

However, the Whirlpool decision does not affect a taxpayer's ability to petition for relief from the throwout rule "as applied" under New Jersey's Section 8.14 This provision permits the Division to adjust a taxpayer's apportionment if the apportionment rules as applied do not properly reflect the entire net income of the taxpayer reasonably attributable to the state.

Prior IHC VDA Treatment

The 2012 policy statement is not the first time that the Division has extended a VDA "olive branch" to IHCs. On March 25, 2008, the Division addressed an open letter to all IHCs that had previously requested VDAs. The letter provided guidance as to how IHCs could attain VDA protection, though the program's ultimate efficacy is debatable.

In addition to the standard business tax VDA terms, this 2008 letter imposed additional requirements on IHCs that had to be met by strict deadlines. VDA participants had to submit fact pattern letters and were subject to a lookback period extending to the later of 1996 or the first date of contact with New Jersey. In addition, the VDA participant had to elect whether to: (a) accept Section 8 treatment that provided, in general, for tax at a rate of 9 percent on all New Jersey source royalty income, or (b) provide information necessary for the Division to assess the throwout component. In addition to the 5 percent post-amnesty penalty, late filing and late payment penalties were imposed, as well as the statutory minimum interest. Until the recent announcement, in most cases involving IHCs the Division has continued to insist on the VDA terms contained in its 2008 letter.

Commentary

New Jersey's latest IHC VDA initiative, while not ideal, provides some additional relief for IHCs that were unaware of their filing obligation, unwilling to abide by the stricter 2008 VDA terms or are waiting for the final resolution of the ongoing "as applied" throwout litigation. For the first time, a waiver of statutory penalties is possible for IHCs (aside from the 5 percent post-amnesty penalty.)

Another benefit is a more limited lookback period. However, while the December 31, 2003 lookback limitation is certainly preferable to the previous 1996 limitation for IHCs, it pales in comparison to the four-year lookback afforded to standard business tax VDA participants.

To the extent an IHC has substantial income from sources other than intangible assets, it can request the standard business tax VDA terms to take advantage of the shorter lookback period. However, New Jersey has indicated that only the smallest proportion of intangible income to total income would warrant such treatment.

New Jersey's latest IHC VDA initiative also allows operating companies that have added back deductions for intangible expenses paid or accrued to related IHCs to amend prior year returns that are open under the New Jersey's statute of limitations to claim an exception to the add-back rules.15 In effect, certain IHCs would only pay the equivalent of three years' worth of tax (2004, 2005 and 2006) when reductions to tax from the offsetting addback exception are considered. To the extent the IHC has deductible expenses such as amortization of intangibles, the tax effect at the consolidated level may even be positive in a given year since the tax paid under VDA by the IHC may be less than the refund received by the operating company. In addition, companies that are carrying a substantial ASC 740 liability can use this opportunity to release that reserve.

On the other hand, New Jersey has a four-year statute of limitations for claiming refunds. As a result there is no offsetting refund opportunity for operating companies that paid substantial tax on account of related-member addbacks in tax years prior to calendar 2007. For calendar year CBT taxpayers who filed on extension, this means that the statute for amending a 2007 return will expire on October 15, 2012. Additionally, the time, effort and expense of preparing and filing amended returns and the possibility that these amendments will trigger audit inquiries should also be considered.

IHCs contemplating participation in the new VDA initiative should carefully consider the effect that the throwout rule will have on their prior period CBT liabilities. Under the new policy statement, the Division "will consider discretionary throwout relief by averaging a throwout receipts fraction with a non-throwout receipts fraction." The operative word here is "discretionary," which implies that the Division could utilize other methods of calculating throwout apportionment. Based upon discussions with the Division, it is apparent that the Division will employ a case-by-case approach in determining an IHC's sales factor, allowing the taxpayer to present its facts and circumstances to support a particular method such as the 2008 approach of applying the flat 9 percent statutory tax rate to royalties from New Jersey sources, or some other mitigating approach.

There is little doubt that this latest VDA initiative for IHCs represents a potential opportunity, subject to vetting case by case, for taxpayers with unresolved exposure related to IHCs. Taxpayers must proceed quickly but with caution, as there are multiple factors to analyze in a relatively short time frame.

Footnotes

1 Policy Statement, Intangible Asset Nexus Initiative, New Jersey Division of Taxation (September 18, 2012).

2 To be eligible for New Jersey's standard business tax VDA: (a) there must have been no previous contact with the taxpayer by the Division; (b) the taxpayer is not registered for the type of taxes that are the subject of the disclosure; (c) the taxpayer is not currently under any criminal investigation; and (d) the taxpayer must be willing to pay outstanding tax liabilities and file the prior year returns within a reasonable period. The taxpayer must submit a written proposal detailing all New Jersey business activity. Statutory interest will be assessed for the tax returns and periods included in the agreement. The taxpayer is expected to remain compliant with all ongoing and future tax obligations.

3 Legislation providing for New Jersey's most recent amnesty (Ch. 21, Laws 2009) program waived penalties and one-half of interest due on tax liabilities originally due between January 1, 2002 and prior to February 1, 2009 but imposed an additional 5 percent penalty, which cannot be waived or abated, on all amnesty-eligible tax amounts that were not paid under amnesty.

4 Geoffrey, Inc. v. S.C. Tax Comm'n, 313 S.C. 15 (S.C. 1993).

5 N.J. ADMIN. CODE tit. 18, § 18:7-1.9(b).

6 N.J. REV. STAT. § 54:10A-2 as amended by Ch. 40 (A.B. 2501), Laws 2002.

7 Lanco, Inc. v. Director, Div. of Taxation, 186 N.J. 245 (N.J. 2006).

8 Quill Corp. v. North Dakota, 504 U.S. 298, 314 (1992).

9 Geoffrey Inc. v. South Carolina Tax Comm'n, 437 S.E.2d 13, 18 (1993).

10 For example, in Tax Commissioner of the State of West Virginia v. MBNA America Bank, N.A., the highest court in West Virginia upheld as constitutional the imposition of tax based on solicitation and receipts derived from sources within the taxing jurisdiction but received by an out-of-state taxpayer. 640 S.E.2d 226 (W. Va. 2006).

11 Praxair Tech. Inc. v. Dir., Div. of Taxation, 988 A.2d 92 (N.J. 2009).

12 N.J. REV. STAT. § 54:10A-6(B). States that have decided not to impose an income or similar business activity tax can be excluded from the New Jersey throwout denominator exclusion calculation. Examples of such states include Nevada, Washington, South Dakota and Wyoming. Whirlpool Properties, Inc. v. Director, Division of Taxation, Supreme Court of New Jersey, 26 A.3d 446 (July 28, 2011).

13 26 A.3d 446.

14 N.J. REV. STAT. § 54:10A-8.

15 N.J. REV. STAT. § 54:10A-4.4. Intangible expenses and costs paid to a related member are deductible to the extent that the payee pays tax to New Jersey on the income stream. N.J. ADMIN. CODE tit. 18, § 18:7-5.18(b)3.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.