United States: Surveying Constitutional Theories for Challenges to the Add Back Statutes

Over the last few years, eleven separate-company filing states have enacted so-called "add back statutes" that disallow a deduction for certain payments made to affiliates. ¹ All of these states target royalties paid for the use of trademarks, tradenames or patents. Most also disallow interest deductions. ² In this article, we briefly survey the basic structure of these statutes with the purpose of identifying Commerce Clause arguments that might be available for challenging all or parts of these statutes. ³

Add back statutes are directed at what states perceive to be an abusive transaction, i.e., a transaction in which a taxpayer creates deductions in separate-company filing states while sourcing the related income to states with favorable tax regimes (e.g., tax regimes that either as a matter of theory or legislative grace don’t tax such income or tax it at a favorable rate).

Maryland’s add back statute is typical. Like most states, Maryland imposes a corporate income tax on a corporation’s Maryland taxable income, which is generally defined as the corporation’s federal taxable income, as modified. See Md. Code §§ 10-102, 10-301 and 10-304(1). With the passage of its add back statute, one of the modifications is a requirement that taxpayers add back the following expenses when calculating their Maryland income:

Md. Code § 10-306.1(b)(2). For this purpose, "interest expense" is defined as "an amount directly or indirectly allowed as a deduction under section 163 of the Internal Revenue Code . . . ." Md. Code § 10-306.1(a)(7). Maryland defines "intangible expense" broadly; it includes an expense directly or indirectly related to the "acquisition, use, maintenance, management, ownership, sale, exchange or any other disposition of intangible property," a loss in connection with discounting and factoring transactions, a "royalty, patent, technical or copyright fee," a licensing fee, as well as any other similar cost or fee. Md. Code § 10-306.1(a)(5). ⁴ "Related members" include stockholders and entities related to them within the meaning of Internal Revenue Code ("IRC") §318 that own at least 50% of the taxpayer’s outstanding stock, component members within the meaning of IRC § 1563, and persons to or from whom there is an attribution of stock ownership within the meaning of IRC § 1563. See Md. Code § 10-306.1(a)(8)-(9).

In contrast to this typical model, North Carolina’s add back statute takes a slightly different tack. Instead of disallowing the expense itself (essentially on a pre-apportioned basis), the North Carolina statute targets only royalty payments received for the use of trademarks in North Carolina and treats all such payments effectively as taxable income derived from doing business in the state. See N.C. Gen. Stat. § 105-130.7A.(a). In the event the payor and the recipient of the royalties are related members, the payments may either (a) be included in the income of the recipient and deducted by the payor, or (b) added back to the income of the payor and excluded from the income of the recipient. See N.C. Gen. Stat. § 105-130.7A.(a). Thus, North Carolina effectively allocates to the state all royalties relating to use of trademarks within the state and then provides the parties a choice as to which (related) entity is to report and pay tax on the income.

Various exceptions provided in the statutes or the regulations temper the broad sweep of the add back statutes. Although the scope and requirements of these exceptions vary between the states, ⁵ the types of exceptions found in the add back statutes may be placed in broad categories to provide a framework for considering their constitutionality.

Before discussing the specifics, it is important to note that certain of the exceptions described below require the taxpayer to demonstrate that the transaction was not entered into for tax avoidance purposes and that the payments reflect arm’s length pricing. ⁶ Moreover, certain of the add back exceptions require the taxpayer to seek approval from the state’s tax agency before the exception may be claimed.⁷ Because these requirements do not appear to implicate the constitutionality of the statutes directly, we do not dwell on them further. Nonetheless, these requirements play an important role in qualifying for many of the exceptions, and thus taxpayers seeking to avoid, rather than challenge, the add back statutes should consult with the state’s requirements to determine whether they should obtain documentation of a business purpose and arm’s length pricing to support their claim of an exception.

Categorizing the Exceptions

In general, the exceptions to the add back statutes fall into seven broad categories. The first exception discussed is the most important and requires a somewhat more extensive discussion. Thereafter we address the other exceptions in a more summary form.

Although the specific form of this exception varies from state to state, several states allow taxpayers to avoid the add back requirement if the recipient is subject to state tax on the associated income.⁸ The key variants among statutes adopting this exception are (1) the benchmark for determining whether the related income is subject to tax, (2) the method for establishing the recipient’s tax burden, and (3) the manner for calculating the add back.

The most distinctive variant is the benchmark, or standard, for determining whether the recipient is subject to a sufficient amount of tax on the related income. Virginia’s exception is the broadest, and merely requires that the recipient be subject to "a tax based on or measured by net income or capital," without specifying a minimum tax rate. Va. Code § 58:1-402(B)(8)(a)(1), (9)(a)(4)(i); see also Ark. Code § 26-51-423(g)(1)(A). The instructions to the Virginia return specify that the inclusion of the income in the recipient’s net income or capital must result "in a non-trivial increase in tax liability (or reduction of an operating loss) after consideration of all of the deductions, credits, exemptions and other tax policies and preferences affecting the tax liability of the related member." Va. Instructions for Form 500-AB (2004).

Most states establish a more significant hurdle by declaration or by using a formula based on the state’s tax rate. For example, Maryland specifies that the recipient must be subject to tax at a rate not less than four percent, see Md. Code § 10-306.1(c)(3)(ii), whereas Connecticut and Massachusetts each condition their exception on the recipient being subject to tax at a rate that is equal to or greater than the state’s statutory rate of tax less three percentage points, see 2003 Conn. Acts § 78(c) (Spec. Session); Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004 (Connecticut’s statutory rate of tax is 7.5%; therefore, the taxpayer "must establish that the interest paid to the related member was actually taxed at a rate no less than 4.5% (7.5% - 3%)); Mass. Gen. Laws ch. 63 § 31J. Finally, New Jersey’s interest add back statute ties its benchmark to the rate of tax applicable to the payor, by requiring the rate of tax applicable to the recipient to be equal to or greater than the rate of tax applied to the payor less three percentage points. See N.J. Rev. Stat. § 54:10A-4(k)(2)(I). ⁹

The second variant is the method used to calculate the recipient’s tax burden to determine whether it has met the benchmark. Several factors affect this calculation. First, the formula itself differs. Connecticut’s statute focuses on the amount of tax the recipient actually pays, and thus determines the recipient’s rate of tax by dividing the amount of tax paid (after credits have been applied) by the recipient’s taxable income before apportionment and net operating loss carryforwards. See Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004.

Maryland makes this calculation by considering the recipient state’s statutory rate of tax and the recipient’s apportionment percentage. See Md. Code § 10-306.1(a)(4); N.J. Reg. 18:7-5.18(a)4.viii. As illustrated in the following example, New Jersey’s interest add back statute similarly considers the state’s statutory rate of tax and the apportionment percentage, but does so for both the payor and the recipient.

Thus, a taxpayer will meet this benchmark as long as its New Jersey apportionment factor is 33% or less and the recipient is subject to tax in New Jersey (even at a nominal amount).

Another factor affecting the calculation of recipient’s tax burden is whether taxes paid in combination or consolidated states count against the benchmark. Most add back statutes only consider taxes paid by the recipient in separate-company filing states. See, e.g., N.J. Reg. 18:7-5.18(a)(5), Ex. 5; Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004; Va. Instructions for Form 500-AB (2004). The theory, of course, is that unitary combination or consolidation states eliminate intercompany payments from income and that, in the simplest of terms, the recipient has no item of income to tax. Maryland, however, recognizes that the tax consequences of combination or consolidation are not necessarily so simple, and thus provides that the payment of the royalty or interest will be treated as taxed to the extent of the lesser of the recipient’s apportionment factor or the combined (or consolidated) group’s apportionment factor. See Md. Code § 10-306.1(e). The effect of this provision can be illustrated as follows:

Another factor affecting the calculation of the recipient’s tax burden is whether the state considers the amount of tax paid to one state or the total amount of tax paid to all states. For example, Maryland seeks to determine the recipient’s "aggregate effective tax rate," which it defines as "the sum of the effective rates of tax imposed by all states, including this state and other states or possessions of the United States, where a related member receiving a payment of interest expense or intangible expense is subject to tax and where the measure of the tax imposed included the payment." Md. Code § 10-306.1(a)(2). New Jersey and Connecticut, on the other hand, only consider the rate of tax paid to one state. See N.J. Rev. Stat. § 54:10A-4(k)(2)(I); Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004. ¹⁰

The third variant that comes into play is the manner in which relief is provided once the payor has proven that the recipient was taxable on the associated income. In most cases, this exception is essentially binary: if the recipient is taxed at a rate at or above the benchmark set by the state, the taxpayer obtains the deduction; however, if the recipient is taxed on the payment but at a rate below the benchmark, the payor obtains no relief. See Ark. Code § 26-51-423(g)(1); N.J. Rev. Stat. § 54:10A-4(k)(2)(I); Md. Code § 10-306.1(c)(3)(ii); 2003 Conn. Acts § 78(c) (Spec. Session). Thus, these exceptions only eliminate double taxation if the corresponding income is subject to tax above a certain threshold, and differ from a typical credit mechanism where the tax imposed by another state reduces the tax imposed upon the taxpayer claiming the credit on a dollar-for-dollar basis.

However, Alabama’s exception allows relief from the add back statute on a sliding scale. More specifically, Alabama requires taxpayers to add back otherwise deductible interest and intangible expenses unless the corresponding item of income is "subject to a tax based on or measured by the related member’s net income." Ala. Code 40-18-35(b)(1). Alabama does not set a minimum rate of tax as its benchmark, but rather specifies that the exception is "allowed only to the extent that the recipient related member includes the corresponding item of income in post-allocation and apportionment income reported to the taxing jurisdiction." Ala. Admin. Code r. 810-3-35-.02(2)(g). In other words, taxpayers are provided relief to the extent that the recipient allocates or apportions its income to separate-company filing states. Thus, if the recipient allocates or apportions 5% of its income to separate-company filing states, the taxpayer is required to add back only 95% of its intercompany interest and intangible expenses. See Ala. Admin. Code r. 810-3-35-.02(3)(g)(1).

In contrast to the exceptions described above, the other exceptions typically found in add back statutes may be readily described.

Many states provide a special exception that is available where the taxpayer demonstrates that the ultimate recipient of the payment is located in a foreign country that has a comprehensive tax treaty with the United States.¹¹ Some states incorporate this exception into their general exception that applies if the recipient is subject to state tax on the corresponding income, and thus similarly require the recipient’s foreign rate of tax to exceed a certain threshold. See 2003 Conn. Acts § 78(c) (Spec. Session); Mass. Gen. Law Ch. 63 § 31J(b); N.J. Rev. Stat. § 54:10A-4(k)(2)(I). However, Arkansas, Connecticut and Virginia have specified that the foreign country exception will apply regardless of the tax rate applicable to the recipient. See Ark. Code § 26-51-423(g)(1)(A); Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004; Va. Code § 58.1-402B(8).

Several states have attempted to limit their add back statute to address only pure intangible holding company structures.¹² For example, Alabama provides that the taxpayer will not be required to add back otherwise deductible expenses if it can establish that the transaction giving rise to the expenses did not have tax avoidance as its principal purpose and the recipient is "not primarily engaged in the acquisition, use, licensing, maintenance, management, ownership, sale, exchange, or other disposition of intangible property, or in the financing of related entities." Ala. Code § 40-18-35(b)(3); see also Miss. Code § 27-7-17(2)(c)(ii) (providing a similar exception where the recipient’s primary business is not related to intangibles).

Virginia provides an exception to its intangible add back provision if the recipient "derives at least one-third of its gross revenues from the licensing of intangible property to parties who are not related members" and the transaction was entered into at arm’s length rates and terms. See Va. Code § 58.1-402B(8)(a)(2).

Certain add back statutes provide an exception for members of specified industries, presumably in recognition that those industries engage in transactions involving intangible assets or intercompany loans as a matter of ordinary business practice. For example, Maryland provides an exception to its add back statute for interest paid by a bank to a bank. See Md. Code § 10-306.1(c)(3)(iii). Virginia also provides an exception to its interest expense add back provision if the recipient has substantial business operations relating to interest-generating activities that require at least five full-time employees; the interest expenses are not related to the acquisition, maintenance, management or disposition of intangible property; and certain other requirements are met. See Va. Code § 58.1-402B(9)(a). Connecticut has a special exception for insurance companies, hospitals and medical service corporations. See 2003 Conn. Acts § 78(c) (Spec. Session); Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004.

Numerous states provide an exception when the income passes through the recipient to a unrelated party.¹³ For example, Maryland’s statute provides that the add back statute does not apply if the recipient "directly or indirectly paid, accrued, or incurred the interest expense or intangible expense to a person who is not a related member" during the same taxable year. Md. Code § 10-306.1(c)(3)(i). New Jersey’s exception to its interest add back statute is more narrow in that it requires that the payor also guarantee the debt for the conduit exception to apply. See N.J. Rev. Stat. § 54:10A-4(k)(2).

Two states (Ohio and Connecticut) also provide an exception that is tied to a combined report or consolidated tax return. In Ohio, this exception limits the tax payable under the add back statute to the amount that would have been payable had the parties filed a combined return. See Ohio Rev. Code § 5733.042(D)(4). In Connecticut, at least in regard to the interest add back, the taxpayer must actually elect to file on a combined basis with all members of the unitary group with which there are substantial intercompany transactions. See 2003 Conn. Acts § 78(d)(3) (Spec. Session). Such an election is irrevocable for five successive income years. Id.

Finally, most add back statutes also contain a catch-all exception that allows the tax authorities and the taxpayer to override the add back where the disallowance of the deduction is "unreasonable" or the parties agree to some alternative apportionment method under an analogue to section 18 of the Uniform Division of Income for Tax Purposes Act.¹⁴ In general, these statutes provide that the taxpayer must carry a heavy burden of proof and may require filing a petition establishing that conclusion prior to filing its tax return. See, e.g., Conn. Dep’t of Revenue Services, Special Notice 2003(22), Jul. 8, 2004 (construing 2003 Conn. Acts § 78(d)(1) (Spec. Session) and indicating that evidence that the add back is unreasonable must be "clear and convincing" and so "clear, direct and weighty" that the Commissioner comes to a "clear conviction without hesitancy" as to the validity of the taxpayer’s claim).

Some states provide guidance as to what would qualify for this exception. For example, New Jersey suggests that the taxpayer must demonstrate the extent to which the recipient pays New Jersey tax on the corresponding income or that the taxpayer is being taxed on more than 100% of its income, see N.J. Reg. 18:7-5.18(a)2 and N.J. Questions and Answers Regarding the Business Tax Reform Act of 2002, Question 7, whereas Alabama suggests that the taxpayer must show that the application of the add back statute causes the tax to bear no fair relationship to the taxpayer’s Alabama presence, see Ala. Admin. Code r. § 810-3-35-.02(3)(h).

Other exceptions contemplate that the taxing authority may issue regulations to provide exceptions for transactions not currently contemplated by the state’s exceptions. For example, Maryland Code § 10-306.1(d)(2) authorizes the issuance of regulations to provide for an alternative treatment where the recipient is subject to tax in another state that is measured by gross receipts, net capital or net worth, rather than income.

In addition to providing exceptions to the add back rule, certain of the add back statutes provide that the computation of taxable income of the taxpayer and the recipient are to be coordinated such that the income associated with the payment is not subject to double tax. Conceptually, this provision is a mirror image of the exception described above where the deduction is allowed if the recipient is subject to tax on the corresponding income. Whereas that exception eliminates the payment from the payor’s income (i.e., the deduction is allowed); here the payment is eliminated from the recipient’s income.

In any event, the scope of this provisim varies among the states. Connecticut, for example, states that the recipient’s Connecticut income and receipts factor is not to include any amounts added back to the payor’s income as a result of the Connecticut add back statute. See 2003 Conn. Acts § 78(f) (Spec. Session). Similarly, New York permits a taxpayer to deduct royalty payments received from related members "unless such royalty payments would not be required to be added back under [New York’s add back provision] or other similar provision in this chapter." N.Y. Tax Law § 208(9)(o)(3). Moreover, North Carolina’s regime effectively reaches the same result by giving the payor and the recipient the choice of which entity is to report the income. See N.C. Gen. Stat. § 105-130-7A.(a), (c).

Maryland’s relief measure goes farther and eliminates the payment from the recipient’s income if that payment has been subject to Maryland’s or another state’s add back provision; however, this adjustment is only permitted if the transaction has a valid business purpose and arm’s length pricing and terms, and is limited to the extent that the aggregate effective tax rate imposed on the recipient exceeds the taxpayer’s aggregate effective tax rate. See Md. Code § 10-306.1(f).

Since the Supreme Court’s decision in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the constitutionality of taxes imposed upon interstate commerce has been evaluated against a four prong test.

• Does the state have substantial nexus with the activity taxed?

• Is the tax fairly apportioned?

• Does the tax discriminate against interstate commerce?

• Is the tax fairly related to the services provided by the state?

To provide a framework for evaluating the constitutionality of the add back statutes, we focus upon the first three of those prongs: namely whether the state has substantial nexus; whether the royalty add back statutes discriminate against interstate commerce; and whether the taxes produced by the add back statutes are fairly apportioned.

The Commerce Clause requirement that a tax on interstate commerce have substantial nexus generally involves two distinct but related inquiries. First, a state must have jurisdiction over the taxpayer it seeks to tax. Generally, this requirement is developed in the context of the physical presence standard of Quill Corporation v. North Dakota, 504 U.S. 298 (1992). Recently, however, states have begun to challenge the fundamental assumption that the physical presence standard is applicable to taxes other than sales and use taxes, e.g., income taxes. Compare A&F Trademark, Inc. v. Tolson, 605 S.E. 2d 187 (2004) (concluding that North Carolina had jurisdiction to impose income tax upon the recipient of royalty payments for the use of intangible property within the state even though the recipient had no physical presence in North Carolina) with Lanco, Inc. v. Dir, Div. of Taxation, 21 N.J. Tax 200 (2003), appeal pending, No. A-003285-03T1 (N.J. Super. Ct. App. Div.) (concluding that New Jersey could not impose income tax on a Delaware intangible holding company because the taxpayer had no physical presence in the state).

The second nexus inquiry involves whether a state has jurisdiction over the income, transaction or property it seeks to tax. In the context of reaching specific items of income earned by a taxpayer doing business within a state (other than the state of the taxpayer’s commercial domicile), the Supreme Court’s decision in Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992) sets the outer boundary as requiring a showing that the income in question serves an "operational" as opposed to an "investment" purpose. Particularly where the state seeks to measure a corporate taxpayer’s income by reference to the income of other corporations (i.e., by requiring a combined report of income), this requirement is also articulated as the unitary business test, typically requiring some showing of functional integration, centralization of management and economies of scale between the entities to be combined. See Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159 (1983).

In simplest terms, the discrimination prong prohibits a state from taxing interstate commerce more harshly than in-state commerce. See Halliburton Oil Well Cementing Co. v. Reily, 373 U.S. 64 (1963). Thus, a state may not impose a heavier tax burden upon a transaction that crosses state lines than would be imposed on a purely intrastate transaction. See Boston Stock Exch. v. State Tax Comm’n, 429 U.S. 318 (1977). Nor may a state’s tax system coerce a taxpayer to move its operations into the taxing state or pressure a taxpayer to limit its investments to in-state entities. See Armco, Inc. v. Hardesty, 467 U.S. 638 (1984); Fulton Corp. v. Faulkner, 516 U.S. 325 (1996).

A state may save a tax that appears to discriminate against interstate commerce by showing that the state’s tax system contains a compensatory or complementary tax on intrastate commerce that effectively levels the playing field. Id. However, a state cannot save a discriminatory tax by showing that the lower tax on local commerce is simply an attempt to avoid a double tax on local businesses. See Armco Inc. v. Hardesty, supra; Farmer Bros. Co. v. Franchise Tax Bd., 108 Cal. App. 4th 976 (2003), cert. denied, 540 U.S. 1178 (2004). In other words, if a state moves to eliminate double taxation of income (e.g., either through a "multiple activities exemption" or through a specific deduction for income that has previously been taxed), the state must extend that relief to eliminate double taxation arising from taxes imposed by other states as well. Id.

The Apportionment Requirement

In recent years, the apportionment prong of the Complete Auto test has been expressed in the internal and external consistency tests first articulated in Container Corporation of America v. Franchise Tax Board, supra¹⁵ Under the internal consistency test, a tax will be struck down if (assuming other states adopt an identical tax) the tax regime would impose a multiple tax burden on interstate commerce where intrastate commerce would bear a single tax burden. See Armco, Inc. v. Hardesty, supra. Thus, under the internal consistency test, the logical risk of multiple taxation is evaluated rather than the actual imposition of multiple taxes. Id.

Under the external consistency test, a tax will be struck down if it extends to values that are not fairly attributable to activity within the taxing state. See Oklahoma Tax Comm’n v. Jefferson Lines, 514 U.S. 175 (1995). The external consistency requirement focuses upon whether the state has adopted a mechanism for apportioning the tax base rather than whether the actual results are supportable as an economic matter. Id.; see also Philadelphia Eagles Football Club, Inc. v. City of Philadelphia, 823 A.2d 108 (Pa. 2003); Northwood Constr. Co. v. Township of Upper Moreland, 573 Pa. 189 (2004). However, broadly viewed at least, the external consistency requirement operates in coordination with the requirement (often expressed in Due Process terms) that a state may not extend its taxing powers to claim income that is all out of proportion to the income earned within the jurisdiction. See Hans Rees’ Sons, Inc. v. North Carolina, 283 U.S. 123 (1931).