Applicable to tax years ending on or after July 1, 2012, Tennessee Governor Bill Haslam has signed legislation that amends the related-party addback rules currently governing intangible expenses for purposes of the corporation excise (income) tax.¹ Pursuant to the legislation, the definition of "intangible expenses" is expanded to include certain interest expenses. Also, the procedure for deducting intangible expenses from related-party transactions is changed substantially, and in certain cases, potentially may require the taxpayer to submit an application to the Tennessee Commissioner of Revenue prior to approval. The legislation also allows Tennessee net worth taxpayers to request from the Commissioner the exclusion of one or more members from its affiliated group.

Existing Law Governing Related-Party Addbacks

The Tennessee corporation excise tax applies to the net earnings of persons doing business in Tennessee.² In determining net earnings or net losses, taxpayers are required to add back "[a]ny otherwise deductible intangible expense paid, accrued or incurred in connection with a transaction with one or more affiliates."³

For tax years ending before July 1, 2012, taxpayers are allowed to subtract from net earnings and losses any intangible expenses paid, accrued or incurred in connection with a transaction with one or more affiliates that has been disclosed.⁴ The disclosure is required to be made on the excise tax return itself (Schedule J and an informational schedule), and the Tennessee Department of Revenue uses the disclosure information to examine the transactions on a case-by-case basis to determine whether such expenses should be allowed as a deduction from net earnings.⁵

In the event that a taxpayer fails to disclose the intangible expenses, and nonetheless deducts those intangible expenses, the intangible expenses are added back to net earnings.⁶ If the addback results in an underpayment, the taxpayer is subject to a negligence penalty equal to the greater of $10,000 or 50 percent of the underpayment amount.⁷

"Intangible expenses" are defined as expenses "related to, or in connection with, the acquisition, use, maintenance or management, ownership, sale, exchange, license, or any other disposition of intangible property to the extent such amounts are allowed or allowable as deductions or costs in determining federal taxable income."⁸

New Procedure Governing Related-Party Addbacks

Expanded Definition of "Intangible Expenses"

For tax years ending on or after July 1, 2012, the legislation expands the definition of an "intangible expense" that must be added back to net earnings, unless an intangible expense deduction is otherwise allowed. "Intangible expense" now also includes "interest expenses directly or indirectly allowed as deductions or costs in determining federal taxable income on a separate entity basis to the extent such interest expenses are ... in connection with the direct or indirect acquisition, use, maintenance, management, ownership, sale, exchange, license, or any other disposition of intangible property."⁹

Notice of / Application for Intangible Expense Deduction

For tax years ending on or after July 1, 2012, the procedure followed by the taxpayer will depend upon the facts and circumstances underlying the related-party expense deduction. The Commissioner is required to approve the deduction of intangible expenses in three situations. The mandatory approval applies to intangible expenses that are paid, accrued, or incurred: (i) "to an affiliate in a foreign nation that is a signatory to a comprehensive income tax treaty with the United States;" (ii) "to an affiliate when the affiliate, during the same taxable year, has directly or indirectly paid, accrued or incurred" the intangible expense to an entity that is not an affiliate; and (iii) "to an affiliate doing business in, or deriving income from, a state that imposes a tax on or measured by net income and, under the state's laws, the affiliate is subject to an income tax in that state."¹⁰

Taxpayers that deduct based on any of these three criteria may simply provide notice of the deduction at the time the return is filed and the taxpayer need not file an application requesting approval.¹¹

With respect to transactions not covered by the three statutorily defined criteria under which the Commissioner must approve the related-party expense deduction, the Commissioner may conduct a conference with the taxpayer and review the facts and circumstances of the taxpayer's proposed deduction. Following the conference, the Commissioner may agree by letter that the taxpayer is not required to file an application.¹² For all other types of transactions, a taxpayer will be required to apply for the deduction, and the Commissioner must determine that the expense in question "did not have as its principal purpose the avoidance of" the excise tax.¹³ The application must be submitted at least 60 days prior to the due date of the return to be filed by the taxpayer.¹⁴ In the event that the application is timely submitted, but the Commissioner has neither approved nor denied the application by the due date of the tax return, no penalty will be assessed based on any disallowance of the deduction.¹⁵

If the Commissioner approves an application, the approval remains in effect as long as the taxpayer submits an annual certification that the facts and circumstances surrounding the transaction remain substantially unchanged.¹⁶ However, the Commissioner may require the taxpayer to reapply for the deduction at least five years after the approved application.¹⁷ In situations where the Commissioner denies the deduction, but the taxpayer deducts the disallowed intangible expense, the Commissioner is directed to assess any applicable tax, interest and penalty resulting from the disallowance of the deduction.¹⁸ However, the taxpayer is entitled to statutory remedies to contest the assessment.¹⁹ The negligence penalty applies to any failure to comply with the addback provisions, as required.²⁰ In the past, the negligence penalty applied to failures to make the required disclosure.

Exclusion of Certain Affiliated Group Members

Tennessee imposes a franchise tax based on a taxpayer's net worth.²¹ Under existing law, a taxpayer that is a member of an affiliated group or a financial institution affiliated group may elect to compute its net worth on a consolidated basis.²² Upon this election, each member of the group is required to compute its net worth on this basis.²³ Effective April 27, 2012, a new provision allows a taxpayer that makes the consolidated basis election to submit a written request to the Commissioner to exclude one or more persons that would otherwise be members of the taxpayer's affiliated group^.24 These persons may be excluded if the Commissioner determines that either: (i) they are included in the taxpayer's affiliated group solely by virtue of a direct or indirect interest and are so operationally remote from the taxpayer that the taxpayer would be unable to obtain the information necessary to calculate the net worth of the group if the persons were included as members; or (ii) they have a direct or indirect interest in both the taxpayer and one or more persons described in (i) and are so operationally remote from the taxpayer that the taxpayer would be unable to obtain the information necessary to calculate the net worth of the group if the persons were included as members.²⁵ The exclusion must result in a fair representation of the affiliated group's consolidated net worth.²⁶

Commentary

In 2004, Tennessee began requiring related parties to add back intangible expenses, unless such expenses were properly disclosed. Tennessee's approach, which differed from other states imposing related-party addback requirements, generated a fair amount of controversy because disclosing the expenses to be deducted substantially increased the chances of the Tennessee Department of Revenue commencing an audit. The Department acknowledged this issue in November 2011 by issuing a notice outlining the compromise potential in disputes involving the deduction of intangible expenses for tax years ending on or before June 30, 2012.²⁷ In the notice, the Department explained that it has "actively reviewed many disclosure forms and other available taxpayer information since 2004."²⁸ Although the Department allowed taxpayers to deduct intangible expenses in some cases, the Department issued assessments disallowing the deduction in cases where it determined that intangible expenses were not related to bona fide, arm's-length transactions. For taxpayers that had intangible expenses disallowed on their merits, or are concerned about potential disallowance on the merits, the Department's offer to compromise and settle any liability or potential liability for tax years prior to the introduction of the new procedure is still something to consider.

For tax years beginning on and after July 1, 2012, the legislation increases the addback requirement in one significant respect by expanding the definition of "intangible expenses" to include certain interest expenses related to intangibles. This change puts Tennessee more in line with other states that impose related-party expense addbacks for a broader range of transactions involving intangibles. Thus, some taxpayers will need to add back a larger amount of intangible expenses. However, the legislation also clarifies when certain transactions are deemed to be noncontroversial so that the Commissioner's application process is only used when truly necessary, and also notes the possibility of agreements that could be struck between the Commissioner and the taxpayer. While the Department's notice will no longer be applicable, pursuant to the dictates of the statute, it would appear that the Commissioner is willing to continue the conversation with taxpayers with respect to what types of related-party intangible expenses may be allowed in part or in full. As a result of the ability for taxpayers to forgo the application process in a number of instances, at first blush, it would appear that the number of applications on which the Commissioner will have to rule would be few and far between, and the likelihood of success with respect to these applications would be slim.

Footnotes

1 Ch. 842 (H.B. 2372), Laws 2012.

2 TENN. CODE ANN. § 67-4-2007. However, not-for-profit or "otherwise exempt" entities are not subject to this excise tax. See Franchise and Excise Tax Guide, Tennessee Department of Revenue, Dec. 2011.

3 TENN. CODE ANN. § 67-4-2006(b)(1)(K). This addback requirement first applied to tax periods beginning on or after January 1, 2004.

4 TENN. CODE ANN. § 67-4-2006(b)(2)(N). An affiliated business entity is "one in which the taxpayer has more than a 50% ownership interest, one that has more than a 50% ownership interest in the taxpayer, or one in which the taxpayer's parent company has more than 50% ownership interest." TENN. CODE ANN. § 67-4-2004(1); Important Notice No. 04-32, Tennessee Department of Revenue, July 19, 2004.

5 TENN. CODE ANN. § 67-4-2006(d); Important Notice No. 04-32, Tennessee Department of Revenue, July 19, 2004; Franchise and Excise Tax Guide, Tennessee Department of Revenue, Dec. 2011.

6 TENN. CODE ANN. § 67-4-2006(b)(1)(K), (d).

7 TENN. CODE ANN. §§ 67-1-804(b)(2), 67-4-2006(d)(2).

8 TENN. CODE ANN. § 67-4-2004(23).

9 Id.

10 TENN. CODE ANN. § 67-4-2006(b)(2)(N)(i)(a) through (c). In the third situation, the portion of the intangible expense that will be approved for the deduction is that portion that, after applying the allocation and apportionment rules of the state, has been allocated or apportioned by the affiliate to that state. Also, the definition of "state" does not include those states under whose laws the taxpayer and the affiliate file or are included in a combined income tax report or return, a consolidated income tax report or return, or any other net income report or return that includes the taxpayer and the affiliate and where the return or report results in the affiliate's intangible income being offset or matched by the taxpayer's deduction in that state's report or return.

11 TENN. CODE ANN. § 67-4-2006(b)(2)(N)(ii)(b).

12 TENN. CODE ANN. § 67-4-2006(b)(2)(N)(ii)(c).

13 TENN. CODE ANN. § 67-4-2006(b)(2)(N)(i). The Commissioner's review of the taxpayer's application must include considerations outlined in the statute that allows variances from the standard apportionment formula. Under this statute, the Commissioner "may apply federal taxation concepts, including but not limited to, 'assignment of income,' 'arm's length,' and 'fair market value' to dealings between and among affiliates." TENN. CODE ANN. § 67-4-2014(c)(3).

14 TENN. CODE ANN. § 67-4-2006(b)(2)(N)(iii)(c).

15 Id.

16 TENN. CODE ANN. § 67-4-2006(b)(2)(N)(iii)(a).

17 Id.

18 TENN. CODE ANN. § 67-4-2006(b)(2)(N)(iii)(b).

19 Id.

20 TENN. CODE ANN. §§ 67-1-804(b)(2), 67-4-2006(d).

21 TENN. CODE ANN. § 67-4-2106.

22 TENN. CODE ANN. § 67-4-2103(d).

23 Id.

24 TENN. CODE ANN. § 67-4-2103(j). The written request must be submitted by the due date of the tax return for the period for which the exclusion would take effect.

25 Id.

26 Id.

27 Important Notice No. 11-17, Tennessee Department of Revenue, Nov. 2011.

28 Id.

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