Multistate taxpayers are all-too-familiar with intangible expense add-back statutes that have become one of the most common ways that state taxing authorities can attack intangible expenses paid to affiliates. Tennessee has been scrutinizing intangible expenses paid to affiliates in recent years and ramped up its attack on these transactions during this Legislative session with the passage of 2012 Tenn. Pub. Law 842, §§ 1-5 (signed by the Governor and effective for all tax years ending on or after July 1, 2012).
Unlike other states that generally require the taxpayer to add back certain intangible expenses paid to affiliates and leave it to the taxpayer to comply with the add-back requirement, Tennessee will not allow a taxpayer under the new law to deduct an intangible expense paid to an affiliate unless the taxpayer files an application with the Department of Revenue, seeking advance approval from the Commissioner of Revenue.
Audits & Assessments
This law follows on the heels of the Department's audit, assessment and settlement with taxpayers that had complied with the former requirement to disclose intangible expenses paid to affiliates. Assessments were made against numerous taxpayers pursuant to the Department's "variance" power to deny deductions based on the premise that the intangible expenses were not paid pursuant to a transaction with a valid business purpose and that the transactions lacked economic substance. Following administrative challenges to these assessments, taxpayers entered into negotiations with the Department to construct a global compromise for open tax periods ending on or before June 30, 2012.
In Excise Tax Notice 11-17, the Department extended this opportunity to compromise tax liabilities for any period ending on or before June 30, 2012, to other taxpayers that had not been audited but voluntarily came forward. Pursuant to this Notice, many other taxpayers that had made intangible expense payments to affiliates approached the Department voluntarily taking advantage of the compromise. The compromise is ostensibly still available for taxpayers that have not been audited and have not voluntarily approached the Department. However, the window on this compromise may be closing.
The new statute requires taxpayers to file an application with the Commissioner for advance approval to deduct intangible expenses paid to affiliates. The Commissioner's consideration of the applications will be to determine whether the expense has "as its principal purpose the avoidance" of the Tennessee excise tax. Review of the application will include consideration of federal taxation concepts to determine whether there are "arm's length" dealings and whether the transaction has a "business purpose" or was entered into with the primary purpose of avoiding excise tax. Taxpayers can look for guidance in published rulings, including Letter Rulings 06-28 and 06-35.
There are three exceptions that, if applicable, would require the Commissioner to approve an application for the deduction of an intangible expense or portion thereof that paid to an affiliate.
- Foreign tax treaty exception: The affiliate is "in a foreign nation that is a signatory to a comprehensive income tax treaty with the United States."
- Conduit exception: The affiliate directly or indirectly pays the intangible expense to an entity that is not an affiliate.
- Subject to tax exception: The affiliate is doing business in or deriving income from a state that imposes an income tax and the affiliate is subject to a net income tax in that state. The portion of the intangible expense that is to be approved for deduction is that portion that has been allocated by the affiliate to the taxing state. The exception does not apply to a state in which the taxpayer and affiliate file a combined or consolidated return that results in the affiliate's intangible income being offset or matched by the taxpayer's deduction on that return.
Applications must be filed 60 days prior to the due date of a return for the taxpayer to avoid penalties. To the extent that the taxpayer wants to challenge the Commissioner's denial of an application, the taxpayer must claim the deduction and challenge an assessment in court. Taxpayers may be subject to a negligence penalty equal to the greater of $10,000 or 50% of any adjustment made to the initially filed return with respect to the new add-back application procedure – a significant deterrent for taxpayers that do not agree with the Commissioner's denial of an application.
Taxpayers that agreed to the compromise
Taxpayers that have entered into the compromise will still have the option of filing an application with the Commissioner to seek approval of the deduction for future periods, or those taxpayers can choose not to claim the deduction.
Taxpayers that have not sought to compromise
Taxpayers that have paid intangible expenses to affiliates but have not voluntarily approached the Department must decide whether to seek protection for tax periods ending on or before June 30, 2012, under the compromise. Those taxpayers will not be permitted to deduct intangible expenses paid to affiliates for years ending after June 30, 2012, unless the taxpayer files an application with the Department to seek advance approval to take the deduction. To the extent that this latter approach is taken and the Department denies the application, the taxpayer's prior tax periods also may be at risk of an audit and assessment. If the Department audits the taxpayer's prior years, the taxpayer no longer will have the option to take advantage of the compromise. Taxpayers in this situation also could choose not to file the application and not claim the deduction for future periods if the taxpayer believes that the application will not be approved. The taxpayers will nevertheless have a risk of audit for open periods.
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.