United States: Kentucky Requires Filing Of Disclosure Schedule For Related-Party Costs

The Kentucky Department of Revenue has announced that for tax years beginning on or after January 1, 2012, corporations and pass-through entities are required to file and attach a Related Party Costs Disclosure Statement (RPC) to their Forms 720, 720S, 765 or 765-GP.1 The Schedule RPC is based on a Kentucky statute providing for the addback of certain deductions for affiliated entities or related parties.2 The Department's release of the RPC is expected to result in a higher level of scrutiny of related-party costs and an increase in audit activity focusing on intercompany transactions.

Statutory Authority

Kentucky Schedule RPC is the Department's newly developed reporting mechanism in response to a statute that adds back certain deductions for expenses paid to affiliated entities or related parties, unless an exception to the addback is met.3 Under the statute, there are three types of expenses that are subject to addback: (1) intangible expenses;4 (2) intangible interest expenses;5 and (3) management fees.6

Taxpayers Subject to Addback Statute

The related members of an affiliated group that are not included in the same nexus consolidated return are subject to the addback provisions.7 The statute defines a related member as a person with respect to the taxpayer during all or part of the taxable year who is: (1) a person or entity that owns at least 50 percent of the taxpayer's equity as defined in IRC Sec. 318; (2) a component member of a controlled group within the meaning of IRC Sec. 1563; or (3) a person to or from whom there is attribution of stock ownership in accordance with IRC Sec. 1563.8

Payments to foreign corporations are also subject to the addback provisions.9 A foreign corporation is defined as a corporation organized under the laws of a country other than the United States and would be a related member if it were a domestic corporation.10

Addback of Certain Deductions

As discussed above, three types of deductions are required to be added back: (1) intangible expenses; (2) intangible interest expenses; and (3) management fees.

Intangible Expenses and Intangible Interest Expenses

An entity subject to the Kentucky corporate income tax is not allowed to deduct an intangible expense11 or intangible interest expense12 paid to a related member, a foreign corporation, or to an entity that based upon ownership interest, would be included in the affiliated group were such entity a corporation.13 Additionally, the expense can be subject to addback whether it is paid or accrued in a direct or indirect manner.

The addback of intangible expenses and intangible interest expenses will not apply if:

1) The taxpayer and the recipient are both included in the same consolidated Kentucky corporation income tax return; or

2) The entity makes a disclosure, and establishes by a preponderance of the evidence that:

a) The payment made to the recipient was subject to, in its state or country of commercial domicile, a net income tax, or a franchise tax measured by, in whole or in part, net income;

b) The recipient is engaged in substantial business activities separate and apart from the acquisition, use, licensing, management, ownership, sale, exchange, or any other disposition of intangible property, or in the financing of related members, as evidenced by the maintenance of permanent office space and full-time employees dedicated to the maintenance and protection of intangible property; and

c) The transaction was at arm's length and at a commercially reasonable rate.14

Management Fees

An entity subject to the Kentucky corporate income tax is not allowed to deduct management fees15 paid to a related member, a related foreign corporation, or to an entity that based upon ownership interest, would be included in the affiliated group were such entity a corporation.16 Additionally, the expense can be subject to addback whether it is paid directly or indirectly.

However, the addback of management fees will not apply if:

  • The taxpayer and the recipient are both included in the same consolidated Kentucky corporation income tax return for the relevant taxable year;
  • The taxpayer makes a disclosure, and establishes by a preponderance of the evidence that the transaction giving rise to the management fees was at arm's length and at a commercially reasonable rate; or
  • The taxpayer and the Department agree in writing to an alternative apportionment method.17

Overview of Schedule RPC

The purpose of Schedule RPC is to specify the disclosure requirements as provided under Kentucky law18 and is now a required supplemental schedule to the following Kentucky forms: Form 720, 720S, 765, or 765-GP.

The Schedule RPC has three main parts. Part I is a disclosure of the three categories of deductions required to be added back: intangible interest; intangible interest expense; and management fees. If the taxpayer discloses the addback in this section, no supplementary information regarding to which entity the expense was paid is required. All that is required is the amount of the expense that is added back.

Part II and Part III of the Schedule RPC work in a complementary fashion. Part II calculates the total amount of exceptions to expenses, as well as the total related-party cost addback after exceptions, and is completed after the information required to be disclosed in Part III is reported.

Part III contains six sections, sections A through F, which require the taxpayer to provide a significant level of detail of the exceptions to the addback. The taxpayer is required to list information that provides evidence that it meets the exceptions for intangible interest and intangible interest expense or that it meets the exceptions for management fees as described above.

Commentary

One of the exceptions to the addback provisions for intangible expenses and intangible interest expenses is that the payment was made to a recipient who was subject to an income tax in the recipient's state of commercial domicile. Officials within the Department have informally indicated that if the exceptions were met19 and the recipient of the intangible income had its commercial domicile in a unitary state, the expense would be added back on the Kentucky return. The recipient of the intangible income would be deemed to not have paid tax on the income in its state of commercial domicile due to the fact that the expense would offset the income when computing taxable income in a unitary state.

A handful of other states that have adopted a "subject to tax" exception from addback have restricted the use of the exception when the recipient of related-party income is subject to tax in a unitary state. However, this rationale would appear to conflict with the regulation20 that interprets the language within the Kentucky statute itself.21 The language in the statute and the regulation is at best unclear as to whether a unitary filing satisfies the requirements of the statute that the income be subject to tax in the recipient's state of commercial domicile. The plain text of the statute only requires that the intangible income be subject to an income tax or a franchise tax, measured in whole or in part, by net income. The regulation further defines "measured by, in whole or in part, net income" to mean that the receipt of the payment by the recipient is reported and included in income for purposes of a tax on net income or in the franchise.22 "Reported and included" means that the item of income was reported and included in income apportioned or allocated to the taxing jurisdiction.

Merely because the recipient of the intangible income has its commercial domicile in a unitary state arguably should not diminish the fact that the intangible income was subject to tax, and was reported and included in income in the unitary state's income tax return. While the expense offsets the income-producing item in a unitary state, the test to maintain the exception to the related-party addback requirement is that the recipient is "subject to tax" on the income, not "actually taxed." Were the recipient domiciled in a separate filing jurisdiction, there would be no offset to the income-producing item, and tax would be paid upon the intangible income. It will be interesting to see how this issue is handled once the Department begins to receive Kentucky Schedule RPCs from taxpayers and the audit process commences.

Another potential issue facing Kentucky taxpayers is that the Department, in challenging the intangible deduction, could attempt to situs the intangible receipts in Kentucky. Officials within the Department have informally indicated that to the extent that the recipient of the intangible income is an entity who otherwise has no Kentucky nexus and is not included in a nexus consolidated Kentucky return, the Department could attempt to assert nexus if it was determined that the intangible property that gave rise to the receipts of the intangible income has situs within Kentucky. This is determined without regard to the corporation's commercial domicile, if possession and control of the intangible personal property are localized in connection with a trade or business, creating business situs23 with Kentucky.24

Factors to be considered in determining if possession and control of the intangible are localized include the following:

  • Use of the intangible property in the continuous course of the trade or business in Kentucky;
  • The permanency of the location of the intangible property in Kentucky;
  • The independent control and management of the intangible property in Kentucky;
  • The possession and control of the intangible property in Kentucky by an independent local agent for the purpose of transacting a permanent business; and
  • The establishment or use of the intangible property in Kentucky in a manner that attaches substantial use and value of the intangible property to the Kentucky trade or business.25

Moreover, if a taxpayer were forced to file a Kentucky return due to intangible income as a result of the requirements stated in the preceding paragraph, and the taxpayer did not meet the requirement of a nexus consolidated return,26 the end result might be inequitable and arguably unconstitutional when viewed in its entirety. In this situation, the two affiliated companies would be forced to file separate Kentucky returns, with the intangible expense added back on the affiliated payor's return, and the intangible income included on the affiliated recipient's return, effectively taxing the same income twice.

Footnotes

1 Kentucky Tax Alert, Vol. 32, No. 1, Kentucky Department of Revenue, Jan. 2013. These forms are the Corporation Income Tax and LLET (Limited Liability Entity Tax) Return (Form 720), S Corporation Income Tax and LLET Return (Form 720S), Partnership Income and LLET Return (Form 765), and General Partnership Income Return (Form 765-GP).

2 KY. REV. STAT. ANN. § 141.205; 103 KY. ADMIN. REGS. 16:230.

3 Id.

4 KY. REV. STAT. ANN. § 141.205(1)(b).

5 KY. REV. STAT. ANN. § 141.205(1)(c).

6 KY. REV. STAT. ANN. § 141.205(1)(d).

7 KY. REV. STAT. ANN. § 141.205(2), (4).

8 KY. REV. STAT. ANN. § 141.205(1)(g).

9 KY. REV. STAT. ANN. § 141.205(2), (4).

10 KY. REV. STAT. ANN. § 141.205(1)(f).

11 Intangible expenses cover a variety of expenses which include, but are not limited to: licensing fees; fees from royalties, patents, and copyrights; and factoring and discounting transactions. KY. REV. STAT. ANN. § 141.205(1)(b).

12 Intangible interest expense means only amounts that would be considered interest under IRC Sec. 163 and the interest is directly or indirectly related to the acquisition, use, maintenance, management, ownership, sale, exchange or other disposition of intangible property. KY. REV. STAT. ANN. § 141.205(1)(c).

13 KY. REV. STAT. ANN. § 141.205(2).

14 KY. REV. STAT. ANN. § 141.205(3)(a), (b); 103 KY. ADMIN. REGS. 16:230.

15 Management fees include, but are not limited to, expenses paid for services related to accounts receivable, accounts payable, employee benefit plans, insurance, payroll, legal, data processing, procurement, tax, accounting, and reporting and compliance services. KY. REV. STAT. ANN. § 141.205(1)(d).

16 KY. REV. STAT. ANN. § 141.205(4).

17 KY. REV. STAT. ANN. § 141.205(5); 103 KY. ADMIN. REGS. 16:230.

18 KY. REV. STAT. ANN. § 141.205; 103 KY. ADMIN. REGS. 16:230.

19 KY. REV. STAT. ANN. § 141.205(3).

20 103 KY. ADMIN. REGS. 16:230.

21 It should be noted that regulations have the same force and effect as any law passed by the state.

22 103 KY. ADMIN. REGS. 16:230

23 103 KY. ADMIN. REGS. 16:240-1.(1)(b). "Business situs" in relation to intangible personal property is the place where the intangible personal property is utilized by the corporation or general partnership.

24 KY. REV. STAT. ANN. § 141.120(8)(c)(3); 103 KY. ADMIN. REGS. 16:270.

25 103 KY. ADMIN. REGS. 16:270.

26 KY. REV. STAT. ANN. § 141.200.

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