This TIR explains the application of newly enacted chapter 63, sections 31I and 31J, which were enacted in March 2003 as outside sections of the supplemental budget legislation. See St. 2003, c. 4, § 17. Sections 31I and 31J, along with several additional provisions that were added by the new legislation, were partly a reaction to the Supreme Judicial Court's decision in The Sherwin-Williams Company v. Commissioner, 438 Mass. 71 (2002), rehearing denied (Feb. 28, 2003). See St. 2003, c. 4, §§ 10, 15, 17, 19-22, 25-28, 84, 87. This TIR also explains the Commissioner's response to the decision in Sherwin-Williams and to Syms Corp. v. Commissioner, 436 Mass. 502 (2002), both of which evaluated deductions for inter-affiliate trademark royalty expenses.
The two new sections, chapter 63, sections 31I and 31J, require that a taxpayer add back to net income certain interest or intangible expenses and costs, subject to certain exceptions. These sections apply to the computation of "net income" pursuant to chapter 63, and therefore apply to foreign and domestic corporations, financial institutions and utility corporations. In addition, the recent legislation has modified the chapter 63, section 30.4 definition of "net income" as it pertains to "dividend notes,"[1] and has clarified and amended the Commissioner's authority to adjust transactions pursuant to chapter 63, sections 33 and 39A. See St. 2003, c. 4, §§ 15, 19-22, 25-28. The new legislation also includes a provision that codifies the "sham transaction doctrine." See G.L. c. 62C, § 3A, added by St. 2003, c. 4, § 10. In sum, these various provisions (the "related party provisions") generally are intended to protect the operation of the state's tax laws to ensure against abusive tax avoidance measures. These sections are not intended to override the application of any specific Massachusetts statute that confers a tax benefit.
The related party provisions were made effective for tax years beginning on or after January 1, 2002. St. 2003, c. 4, § 87. The Legislature also stated that these provisions were intended to clarify its "original intention" as embodied in the General Laws that a taxpayer seeking to claim a tax benefit in connection with a transaction must show "a valid, good-faith business purpose, other than tax avoidance" and "economic substance apart from the asserted tax benefit." St. 2003, c. 4, § 84. See also St. 2003, c. 4, § 87 (noting the Commissioner's authority, even prior to the date of the recent legislation, to "adjust taxpayer transactions for want of an adequate business purpose").
A. Tax Years Beginning On or After January 1, 2002: The Required Statutory Add Back of Certain Intangible and Interest Expenses and Costs
The two new sections, chapter 63, sections 31I and 31J, require that a taxpayer add back to net income related member interest and intangible expenses and costs, including losses incurred in connection with factoring or discounting transactions. G.L. c. 63, §§ 31I, 31J, added by St. 2003, c. 4, § 17. These sections are mandatory, but are subject to certain statutory exceptions. The statutory exceptions generally are predicated on the taxpayer being able to show by clear and convincing evidence that a particular add back would be unreasonable. See id. A taxpayer that seeks to claim that an add back would be unreasonable must do so on one of two schedules ("Schedules," or individually "Schedule") completed as required by the Commissioner and filed as part of its tax return. Copies of the Schedules, ABI and ABIE, are available for review at on the Commissioner's web site, www.mass.gov/dor.
A taxpayer that completes and submits a Schedule as required may take a claimed deduction on its tax return despite the fact that the underlying transaction may be subject to a statutory add back. The taxpayer retains the burden of proving that the application of the add back is unreasonable or that another statutory exception applies. See G.L. c. 63, § 31I(c), 31J(a) added by St. 2003, c. 4, § 17. A taxpayer must state the basis for its claimed exception on the Schedule, which will then be subject to review as more generally set forth below.
The two Schedules pertain, respectively, to a claimed exceptions for either interest or intangible expenses. Each Schedule consists of two parts. The first part of each Schedule permits a taxpayer to claim that an add back would be unreasonable because it would result in actual double taxation as that term is used for purposes of this TIR. The second part of each Schedule permits a taxpayer that cannot use Part 1 to attach a statement explaining why it should be entitled to an add back exception. The total amount of exceptions claimed by a taxpayer on the two Schedules is to be totaled and separately referenced on the designated line of the taxpayer's tax return. The two parts of the Schedules are discussed in greater detail below.
2. Part 1: Double Taxation - Presumptive Approval
Part 1 of each Schedule permits a taxpayer to claim that an add back would be unreasonable because it would result in actual double taxation. Part 1 of each of the Schedules permits a taxpayer to establish the existence of actual double taxation as to itself and one or more of its related members. Three specific exceptions relating to double taxation may be claimed in Part 1 of either Schedule.
The first Part 1 exception applies where the taxpayer incurs a cost or expense to a related member entity that is taxed on the corresponding income by a U.S. state or foreign jurisdiction at an effective rate of tax that is within three percentage points of the taxpayer's statutory Massachusetts rate. In these cases, demonstrating actual double taxation as defined herein will be sufficient to establish that the transaction was not intended for tax avoidance purposes and therefore the taxpayer will be entitled to an exception for the entire amount of the add back. This exception applies to transactions with one or more related members. However, for purposes of verifying the taxpayer's claim, the Commissioner requires that the taxpayer retains and produces upon request a copy of each related member's tax return. Also, this exception does not apply to transactions with a related member when that related member files in another jurisdiction with the taxpayer on a combined or unitary basis. In these latter cases, there generally is no actual double taxation because the intercompany payment giving rise to the deduction is eliminated.
The second and third Part 1 exceptions are partial exceptions that apply to the specific portion of a taxpayer's cost or expense that is taxed to one or more related entities or individuals on a Massachusetts tax return. In these cases, the exception will apply to that portion of the cost or expense that is actually subject to double tax.[2]
Each of the Part 1 exceptions referenced on the Schedule that pertains to the interest add back applies to dividend notes. See G.L. c. 63, § 30.4(4), added by St. 2003, c. 4, § 15. However, these exceptions do not apply to certain transactions in which interest is paid to an unrelated party in connection with debt that was used to acquire the taxpayer's assets or stock. G.L. c. 63, § 31J(c), added by St. 2003, c. 4, § 17.
When a taxpayer files a Schedule seeking a Part 1 exception, the Commissioner will presume that that asserted exception is warranted subject only to a subsequent review or audit. The Commissioner recognizes that there may be instances of actual double taxation that cannot be evidenced on Part 1 of the Schedule. For example, there may be cases in which a taxpayer seeks a full exception with respect to a related member that is an individual or a partial exception with respect to a related entity or individual that does not file a Massachusetts return. In these cases, the taxpayer may seek to claim the existence of actual double taxation through Part 2 of the Schedule, as discussed below.
3. Part 2: Statement Supporting an Add Back Exception
When a taxpayer seeks to claim an exception to a statutory add back that cannot be claimed under Part 1 of the Schedule, this claim must be made pursuant to Part 2. In these cases, the taxpayer may assert the claimed exception on a statement ("Statement") that is included in its Schedule.
A taxpayer's Statement must provide sufficient information to support a conclusion by the Commissioner that it would be unreasonable to apply the statutory add back to its claimed deduction. Except in one instance, as noted below, the standard of proof that applies to the taxpayer must meet concerning this issue is "clear and convincing evidence." In general, the Commissioner will require that the taxpayer's Statement establish that the transaction at issue was entered into for a valid business purpose other than tax avoidance and that the transaction is supported by economic substance. The Commissioner will also consider whether the asserted business purpose is commensurate with the value of the deduction claimed.[3] Clear and convincing evidence is evidence that is so "clear, direct and weighty" that it will permit the Commissioner to "come to a clear conviction, without hesitancy" of the validity of the taxpayer's claim. See United States v. Goba, 220 F. Supp. 2d 182, 188 (W.D.N.Y. 2002) ( quoting Cruzan v. Missouri Dep't of Health, 497 U.S. 261, 285 (1990)).[4] Unless all relevant evidence is incorporated into the taxpayer's Statement and accompanying attachments, the Statement should identify the other evidence on which the taxpayer relies, and the taxpayer must retain this evidence so that it can be made available to the Commissioner upon his request. See 830 CMR 62C.25.1 (record retention).
The Commissioner will entertain three types of Part 2 claims, as set forth below. Any taxpayer that seeks a Part 2 exception must specify on the Schedule the type of exception that is being claimed. The taxpayer's Statement should follow the guidelines below. In each case, the taxpayer should include the requested information and identify the requested evidence. Further, the taxpayer should provide any additional information and identify any additional evidence that would be necessary or helpful to process its add back exception claim.
a. Royalty Payments through a Related Member Conduit
In the case of an intangible property transaction, the taxpayer may claim in its Statement that, although a portion of its royalty payments were made to a related member, the related member during the same taxable year directly or indirectly paid, accrued or incurred such portion to a person that was not a related member, and the transaction did not have tax avoidance as a principal purpose. See G.L. c. 63, § 31I(c)(ii), added by St. 2003, c. 4, § 17. In these cases, the Commissioner's criteria for evaluating the legitimacy of the transaction will be the same as that generally stated for Part 2 above, except that the evidence standard is "preponderance of the evidence" and not the more rigorous "clear and convincing evidence" standard. See id. In general, a taxpayer should state that the intangibles payments were made, first, between the taxpayer and a related member and, second, between the related member and an unrelated party. If the two sets of payments are not identical in kind or amount or in any other respect the taxpayer should explain the basis for the discrepancy. Also, the taxpayer should state whether the payments were made in either case pursuant to one or more written agreements and if so should briefly describe each agreement. Further, the taxpayer should state how the taxpayer actually used the intangible property in question.
b. Other Instances of Double Taxation
A taxpayer that is unable to use Part 1 pertaining to actual double taxation may nonetheless claim in Part 2 that it possesses clear and convincing evidence to support a similar claim. As in the case of Part 1, the taxpayer may make one of two double taxation claims. First, the taxpayer may claim that it should be entitled to an add back exception for its entire interest or intangible cost or expense since this cost or expense is subject to significant actual double taxation in this state or another jurisdiction. A claim of significant actual double taxation requires that the taxpayer state that its related member or members are taxed on the income in question at an effective rate of tax that is substantially equivalent to the taxpayer's Massachusetts tax rate. A rate of tax that is substantially equivalent to the taxpayer's Massachusetts tax rate is the taxpayer's statutory rate of tax pursuant to chapter 63 minus three percentage points. See G.L. c. 63 § 31J(b), added by St. 2003, c. 4, § 17.[5] Second, the taxpayer may claim that it should be entitled to a partial exception for the specific amount of the interest or intangible cost or expense that is subject to actual double taxation in either Massachusetts or some other state or foreign jurisdiction.
A taxpayer that states in Part 2 that it is subject to actual double taxation, as noted above, should explain the basis for this claim. The Statement should identify the tax jurisdiction or jurisdictions in which the related member is subject to tax and whether the related member previously paid tax pursuant to a filed return to this jurisdiction in connection with the cost or expense in question. For purposes of this claim, the taxpayer may analogize, as appropriate, to the calculations set forth on Part 1 of the pertinent Schedule.
In general, a claim of double taxation should not be based upon taxation applied to a related member by a state in which that related member is filing with the taxpayer on a combined or unitary basis. In these cases, the taxpayer's intangible or interest expense and the corresponding income of the related member will "wash" for purposes of the combined or unitary filing and therefore the filing will not result in actual double taxation. A taxpayer can claim double taxation vis-à-vis a state in which the taxpayer and its related member file on a combined basis when the taxpayer can prove that the taxpayer and its related member have separately computed their taxable income for filing purposes. See, e.g., G.L. c. 63, § 32B (permitting "combined" filings of this type). In these cases, in addition to the information stated above, the taxpayer should identify the referenced state and assert that the taxpayer and the related member computed their income separately. Also, the taxpayer should specifically explain how the application of the tax law in the state in question resulted in double taxation.
As in the case of Part 1, a claim of actual double taxation may be made under Part 2 of the interest add back Schedule in the context of a dividend note. See G.L. c. 63, § 30.4(4), added by St. 2003, c. 4, § 15. In these cases, the taxpayer should describe the transaction and state the material terms of the note, including the date, term, principal and the interest payment schedule. In contrast, a claim of double taxation cannot be made in the context of certain transactions in which interest is paid to an unrelated party in connection with debt that was used to acquire the taxpayer's assets or stock. See G.L. c. 63, § 31J(c), added by St. 2003, c. 4, § 17.
c. Other Transactions
In all other cases, the taxpayer's Part 2 Statement should be supported by clear and convincing evidence that the transaction at issue was entered into for a valid business purpose other than tax avoidance and possesses economic substance. See G.L. c. 62C, § 3A, added by St. 2003, c. 4, § 10. Further, the taxpayer should state that there is clear and convincing evidence to show that its interest or intangible cost or expense was appropriate within the meaning of chapter 63, sections 33 and 39A. See G.L. c. 63, §§ 33, 39A (requiring that there be "fair value" or "fair consideration" paid in connection with affiliate transactions). The business purpose(s) referenced on the taxpayer's Statement should also be commensurate with the value of the deduction claimed. See G.L. c. 62C, § 3A, added by St. 2003, c. 4, § 10.
i. Statement of Business Purpose and Economic Substance
The Commissioner recognizes that any determination whether an adequate business purpose existed for a transaction must be based on the overall facts and circumstances, and that many business purpose issues can be are highly subjective in nature. Nonetheless, the Commissioner will seek to apply an objective approach to the business purpose and economic substance inquiries, taking into account appropriate business realities. Taxpayers are encouraged, therefore, to include in their Statement business purpose and economic substance justifications for their intercompany transactions.
The taxpayer's business purpose or purposes for its transaction should be stated as specifically as possible and not stated in the abstract. Also, the purpose or purposes stated should relate to the particular transaction for which the deduction is being claimed and not, for example, to the formation of the related member entity that takes part in the transaction. Further, the taxpayer's business purpose or purposes should be related to discrete business activity that is conducted by the taxpayer or activity that the taxpayer is planning to conduct. In addition to its statement of business purpose, the taxpayer should identify each of the elements of the transaction that it relies upon to support a finding of economic substance. As noted below, if the Commissioner does not accept the taxpayer's claimed exception, the taxpayer will have an the opportunity for a hearing before the resulting tax is assessed.
Although the Commissioner will seek to evaluate taxpayer transactions objectively, he nonetheless will consider the asserted deduction of an intangible royalty payment with skepticism, consistent with the decision in Syms Corp. v. Commissioner, 436 Mass. 502 (2002). In these situations, as noted by Syms, the taxpayer's proffered business purposes may be generic to the intangible holding company structure and not the specific consequence of the operation of the taxpayer's business. Further, the Commissioner understands that an intangible holding company structure that is undertaken for tax avoidance purposes can be accomplished by establishing the holding company in a unitary state, as opposed to Delaware or another "tax haven" state.
ii. Description of Transaction; Basis for the Payment Amounts
The taxpayer's Statement should provide a detailed description of the transaction that generated the claimed deductions in question. For example, if the deduction was claimed pursuant to a written contract, the taxpayer should briefly describe the contract, including the date and the relevant terms. If the taxpayer entered into the transaction on the advice of a tax advisor, or the terms of the engagement with a tax advisor measured the fee paid to the advisor directly or indirectly by reference to the actual or anticipated tax savings derived from the transaction, the taxpayer should note this fact. In these latter circumstances, the Commissioner is more likely to reject the add back claim.
Further, the taxpayer must state the basis for its determination that the amount of the cost or expense in question was substantially identical to what would be expended in an arm's length transaction under substantially similar circumstances. See G.L. c. 63, §§ 33, 39A. In making this statement the taxpayer may make reference to appropriate rules concerning arm's length charges set forth in Internal Revenue Code § 482, including the rules that relate to the imposition of an arm's length rate of interest. See In re Tropicana Sales, Inc., DTA Nos. 815253, 815564, 2002 N.Y. Tax. LEXIS 162 (NY Tax Trib. 2002) (evaluating how "uncontrolled comparables" can be used to show "arm's length" pricing). If for purposes of showing that the amount of its expense was fair, the taxpayer is relying upon an appraisal or a study, the taxpayer should identify this appraisal or study and its preparer, and state the date on which it was issued and the general conclusions thereof. The add back statute requires that a taxpayer prove that its cost or expense is appropriate. Therefore, where a taxpayer cannot show by clear and convincing evidence that the amount of its asserted deduction was fair, the Commissioner in his discretion may adjust the cost or expense so that it will reflect fair value or, alternatively, deny the taxpayer's exception claim in its entirety.
iii. Statement that there was no "Circular Flow of Funds"
The taxpayer's Statement should indicate whether the cost or expense in question was actually paid and, if so, whether it was substantially returned to the taxpayer in whole or in part. In cases in which the cost or expense was returned to the taxpayer either in whole or in part, the taxpayer should state when this cost or expense was returned to the taxpayer. The Commissioner notes that he will generally reject a Part 2 "other" claim when it is based upon a purported cost or expense with respect to which no actual transfer of funds was made or with respect to which one in which funds were substantially returned to the taxpayer, either directly or indirectly, within a short period of time.
iv. Statement as to the Management of the Transacting Parties
In general, the Commissioner will be more likely to accept an add back claim when the two affiliates are not controlled or managed on a day-to-day basis by the same persons and the same persons did not occupy both sides of the bargaining table. This will be particularly so when the two companies were previously independent entities or, if not previously independent, function like independent entities without interconnected activities or overlapping interests. The taxpayer's Statement should note whether the taxpayer believes that the transaction was in fact negotiated by related members who were dealing with each other on an arm's length basis. At the same time, the Commissioner recognizes that in many controlled-group contexts, related members will not in fact conduct arm's length negotiations. If the terms of an agreement between related members are substantially the same as those that unrelated parties would have entered into, the fact that the overall organization of which the related members form a part is centrally managed will not, by itself, preclude relief from the add back provisions.
v. Statement as to the Acquisition of Intangibles
In the case of an intangibles transaction, the taxpayer's Statement should explain how the related member obtained the intangibles in question. In general, the Commissioner will be more likely to approve an intangible cost or expense when the intangibles were either developed by the related member that receives the payment or were purchased by this related member in a bona fide sales transaction.
vi. Statement of Capitalization for Purposes of Loan Payments
In the case of an interest deduction, the taxpayer's Statement should briefly explain what the taxpayer's capital structure was at the time that it incurred the debt in question. In many instances a copy of the taxpayer's separate-company balance sheet on its Massachusetts tax return for the year the debt was incurred will suffice for this purpose. The Commissioner generally will also review the taxpayer's balance sheet for the year of the potential add back as part of his analysis of the adequacy of the taxpayer's capitalization. The taxpayer's Statement may include such other information as the taxpayer believes may be helpful in assessing its capital structure.
vii. Statement as to Whether the Loan is "Acquisition Debt"
In the case of an interest deduction, the taxpayer's Statement should also indicate whether the underlying debt represents debt that was originally used to acquire the stock or assets of the taxpayer in a transaction that is referenced in Section 368 of the Internal Revenue Code. See G.L. c. 63, § 31J(c), added by St. 2003, c. 4, § 17. In general, an interest deduction will not be regarded as appropriate in such cases.
2. Examples
The following examples are intended to illustrate the application of the add back exceptions. In each of these examples, it should be assumed, unless otherwise stated, that there is no significant actual double taxation that would result from the add back in question and that the issue is whether an add back exception should be allowed for the entire expense. Also, it should be assumed that in each case the taxpayer has filed a completed Schedule requesting an exception to the statutory add back as part of its tax return. Further, it should be assumed that there are no additional material facts or circumstances that would alter the determination as stated in each example. In each case in which an example refers to a taxpayer's proof that its transaction was not entered into for a tax avoidance purpose, the example refers to the proof that is generally required for purposes of a Part 2 add back exception claim. This includes proof that economic substance and a valid business purpose other than tax avoidance support the transaction, and also proof that the business purpose is commensurate with the amount of the deduction claimed.
1. Abel Corp. is engaged in manufacturing operations in Massachusetts and has been licensing technology from Baker Corp., an unrelated out-of-state corporation. Baker Corp. acquires a controlling interest in Abel Corp., but Abel Corp. continues to use Baker Corp's technology pursuant to the pre-existing licensing contract. The Commissioner will recognize an exception to the statutory add back for the royalties paid by Abel Corp. to Baker Corp. pursuant to the pre-existing licensing contract.
2. An out-of-state corporation, Carter Corp., licenses intangibles that it owns and has developed to unrelated out-of-state entities that manufacture and sell goods to which the intangibles relate. The unrelated entities pay a royalty fee to Carter Corp. that comprises payment for manufacturing-related intangibles and also for an exclusive right to sell the manufactured product within a defined region. Carter Corp. forms Delta Inc., a wholly owned corporation that is to operate stores in Massachusetts. Carter Corp. causes Delta Inc. to enter into a contract with it pursuant to which Delta Inc. will have the exclusive right to sell products that are manufactured by another subsidiary of Carter Corp. within a certain territory. The terms of this licensing contract require Delta Inc. to pay Carter Corp. a royalty fee in connection with its in-state retail sales. Although Delta Inc., unlike Carter Corp.'s unrelated licensees, merely sells products that it purchases from Carter Corp., the percentage royalty that Delta Inc. seeks to deduct is similar to that paid by Carter Corp's unrelated licensees. It is assumed for purposes of this example that Delta Inc. can show that the transaction was not entered into for tax avoidance purposes. However, note that despite this assumption the royalty paid by Delta Inc. is apparently in excess of fair value. Therefore, in the absence of other facts to support the amount of Delta Inc.'s asserted royalty deduction, the Commissioner will either deny will not recognize the claimed add back exception or adjust the royalty to correspond to an arm's length rate.
3. Exit Corp., a Massachusetts utility corporation that is subject to tax under G.L. c. 63, § 52A, has an outstanding loan in place with Fire Co., which is an unrelated corporation doing business outside the state. Fire Co. later acquires Exit Corp. and Exit Corp. Fire Co. continues to make interest payments to Fire Co. Exit Corp. in accordance with the pre-existing loan agreement. The Commissioner will recognize an exception to the statutory add back for the interest paid by Exit Corp. to Fire Co. pursuant to the pre-existing loan contract.
4. Groom Corp. is engaged in manufacturing operations in Massachusetts and is acquired by Hire Corp., which is an out-of-state corporation that is in a service business. Although Hire Corp. formally controls Groom Corp. by reason of its acquisition, Hire Corp. retains the separate management of Groom Corp., which continues to run the operations of that entity independently. The officers of Groom Corp. determine that they need to take on debt to fund expansion of the manufacturing business. Although Groom Corp. could borrow funds from an unrelated party, its officers decide to borrow these funds from Hire Corp. Groom Corp. and Hire Corp. then enter into a formal loan agreement and Groom Corp. subsequently uses the borrowed funds as planned. Although Groom Corp. does not immediately use all of the loan proceeds received from Hire Corp., it retains these funds for future use. Further, Groom Corp. makes regular payments on the loan in accordance with the loan terms. Assuming that the terms of the loan, including the stated interest rate, closely resemble what would be used in an arm's length transaction under substantially similar circumstances, the Commissioner will recognize an exception to the statutory add back.
5. Idle Corp., an out-of-state corporation, enters into an agreement with an unrelated corporation, Sell Corp., to acquire Jewel Co., a Massachusetts corporation that is a wholly owned subsidiary of Sell Corp. Subsequent to the acquisition of Jewel Co., Jewel Co. declares a dividend of a note to Idle Corp. that substantially replicates the terms of Idle Corp.'s loan agreement with the unrelated lender. The dividend is declared in connection with Idle Corp.'s acquisition of Jewel Co., but was principally intended to create tax deductions on the part of Jewel Co. The Commissioner will not recognize an add back exception for interest deductions that are asserted by Jewel Co. in connection with the dividend of the note.
6. An individual, Mr. Knoll, owns and operates Luther Corp., a profitable Massachusetts corporation. Mr. Knoll acquires Mother Inc., a second Massachusetts corporation engaged in a similar line of business, which Mr. Knoll will also manage. Mother Inc. is profitable during the tax year in question, but because it has substantial net operating losses from prior years, it will have not have any Massachusetts tax liability for the tax year. In fact, there is a real risk that most of Mother Inc.'s net operating loss carry forwards will expire unused for Massachusetts purposes. Mr. Knoll causes Mother Inc. to loan monies to Luther Corp. to use in Luther Corp.'s general operations and also causes Luther Corp. to make regular payments on the loan. Most of the funds that are lent to Luther Corp. are not actually used in its general operations during the tax year at issue. These facts suggest that the loan transaction between Luther Corp. and Mother Inc. may have been entered into for tax avoidance purposes. The Commissioner will not recognize an exception to the statutory add back for the interest deductions that are asserted by Luther Corp. unless Luther Corp. can provide the requisite evidence to prove that the transaction was not entered into for tax avoidance purposes.
7. Niles Co. is a technology start-up corporation doing business in the state that is owned by two individuals, one of whom resides in Massachusetts and one of whom does not. Niles Co.'s rate of tax under the Massachusetts statute is 9.5%. The rate at which the Massachusetts resident is taxed is 5.3% and the rate at which the non-resident is taxed is 4.75%. To help fund the expansion of the business the two individuals loan monies to the corporation and execute notes reflecting arm's length interest and terms that would pass muster under Internal Revenue Code § 482. There are no factors that suggest that the loan should be recharacterized as a contribution to capital. Further, Niles Co. uses the loan funds in its business, and makes regular payments on the loan in accordance with the loan terms. Because Niles Co. can make the requisite showing that the transaction was not for tax avoidance purposes, the Commissioner will recognize a full exception to the statutory add back. Note that a full exception based on the notion of substantial actual double taxation would not be appropriate on these facts because neither of the two related individuals is taxed at a rate of tax within 3% of Niles Co.'s statutory in-state rate. However, if a full exception were not appropriate, the Commissioner would recognize a partial exception to the statutory add back based upon the fact that each of the two individuals were actually taxed on the interest income in question.
8. Orange Corp. is a corporation that is engaged in business in Massachusetts and is taxed at a statutory rate of 9.5%. Purple Corp. is a related member corporation that loans funds to Orange Corp. Purple Corp. apportions one-quarter of its income to each of the following states and is taxed on the interest income at the rate noted: Connecticut (7.5%), Kentucky (8.25%), Louisiana (8%), and Maryland (7%). Purple Corp. has no property, payroll or sales or any other activity in any other state. Given these facts, Purple Corp.'s effective tax rate in each of the four states referenced is Connecticut (1.875%), Kentucky (2.065%), Louisiana (2%), and Maryland (1.75%). Purple Corp.'s total effective tax rate, determined by adding the four state effective rates, is 7.69%. Because Purple Corp is actually taxed on the interest income in question at a total effective tax rate that is within 3% of the state tax rate of Orange Corp., the Commissioner will recognize a full exception to the statutory add back.
9. A parent corporation, Parent, owns a controlling interest in two subsidiaries, Result Corp. and Sister Inc., which conduct business operations solely in Massachusetts. Result Corp. conducts general business operations, whereas Sister Inc. is an insurance company within the meaning of G.L. c. 63, §§ 20 et seq. Parent capitalizes Sister Inc. with more money than it needs to conduct its insurance operations and then causes Sister Inc. to lend the excess cash to Result Corp. Interest payments made by Result Corp. to Sister Inc. are not taxable to Sister Inc. because insurance companies are only taxable on their insurance premiums. These facts suggest that the loan transaction between Result Corp. and Sister Inc. may have been entered into for tax avoidance purposes. The Commissioner will not recognize an exception to the statutory add back for the interest deductions that are asserted by Result Corp. unless it can provide the requisite evidence to prove that the transaction was not entered into for tax avoidance purposes.
10. Total Co., a multinational corporation with its headquarters in Freedonia, has significant operations in the U.S. Its U.S. commercial domicile is in Massachusetts. At the recommendation of its tax advisors, Total Co. creates an U.S. holding company, Usher Corp., which is treated as a branch of its Freedonian parent for Freedonian tax purposes. Usher Corp. is an "eligible entity" that checks the box to be treated as a corporation for purposes of U.S. tax law. Also, at the recommendation of its tax advisors, Usher Corp. declares a dividend to its parent, Total Co., in the form of a note in the amount of $100 million, and then deducts the interest expense attributable to the note on its U.S. tax return. Usher Corp. must add back the interest expense on its Massachusetts tax return, because there is no actual double taxation in the jurisdiction where the interest income is received, and no evidence that the transaction was entered into for a valid business purpose other than tax avoidance purposes.
11. Ms. Victor, who is a resident of Massachusetts, is the president and sole owner of Wire Inc., a C corporation that owns several video stores and is only doing business in this state. To help fund expansion of the business, Ms. Victor makes a loan of $100,000 to Wire Corp. on arms-length terms, and Wire Inc. executes a ten-year note reflecting these terms. Funding the business expansion is appears to be the sole purpose for the loan and the transaction was not does not appear to have been entered into for tax avoidance purposes. There are no other circumstances suggesting that the loan should be re-characterized as a capital contribution, and also the required payments generally are made timely. The Commissioner will not add back the interest expense incurred by Wire Inc. because disallowing the deduction would be unreasonable in these circumstances, notwithstanding the fact that there is more than a 3% difference between Wire Inc.'s 9.5% Massachusetts rate and Ms. Victor's 5.3% Massachusetts tax rate.
In the seventh year of the loan, Ms. Victor turns over day-to-day management of Wire Corp. to her son and retires to Florida, where she establishes her exclusive tax domicile. Even though Florida imposes no personal income tax, the Commissioner will not add back the interest expense incurred by Wire Inc. for the years after Ms. Victor moves to Florida.
12. Same facts as example 11, except that Ms. Victor owns the corporation, Wire Inc., through her 100% interest in a Massachusetts business trust, Trust Co., which is a holding company trust that is exempt from state income tax under G.L. c. 62, § 8(b)(ii). Rather than make the loan to Wire Inc. directly, Ms. Victor advances the funds to Trust Co., which then makes the loan to Wire Inc. Ms. Victor structures the transaction in this manner so that the interest on the loan will not be subject to state income tax. Although there is a valid business purpose for a loan between Ms. Victor and Wire Inc., there is no valid business purpose for the loan between Trust Co. and Wire Inc. Consequently, the Commissioner will not recognize an exception to the statutory add back on these facts.
13. Yoga Corp. operates retail stores in Massachusetts and other states in which it sells products that bear the company's trademarks. Yoga Corp. is taxable in each of the states in which it operates a retail store. Yoga Corp. is headquartered in a state that taxes the income of Yoga Corp. and all of its "unitary" affiliates on a combined basis. A tax consultant advises Yoga Corp. that it can save money on its state taxes vis-à-vis Massachusetts and other "separate tax reporting" states by separately incorporating an intangibles holding company, Zero Inc., in the unitary state in which it is headquartered. Under the plan, Yoga Corp. will transfer its trademarks to Zero Inc. and then begin paying a royalty for the use of these trademarks, based upon a percentage of sales made in Massachusetts and the other states. Yoga Corp. will deduct royalty payments paid to Zero Inc. and thereby decrease its taxable income in separate tax reporting states like Massachusetts. Under the plan, Zero Inc. will be established with limited property and payroll, such that Zero Inc. will only be taxable in the unitary state in which it is based, in which state it will file with its parent, Yoga Corp., on a combined basis. Because the royalty payments made between Yoga Corp. and Zero Inc. will "wash" in the unitary state, they will have no state tax consequences in that state. Because the royalty transaction was entered into to avoid state income tax, the Commissioner will not recognize an exception to the statutory add back on these facts.
14. Calco is a California-based business that was formed in 1995. It owns a number of franchised fast-food restaurants, each of which is operated through a separate, direct subsidiary of Calco Inc., the corporate parent. Calco Inc. performs Calco's headquarters function and operates solely in California. The Calco group derives its income exclusively from sales at the fast-food restaurants. The group pays license fees for each of the restaurants to a large, unrelated multinational company that owns the intangibles associated with the restaurant chain. Calco has been expanding its operations steadily since its formation by acquiring more and more restaurants. Until 2001, all of its restaurants were located in California. Calco's practice in acquiring the restaurants has always been to set up a new subsidiary, determine the funds that it needs to acquire the restaurant, and capitalize the new subsidiary with such funds by using 60% equity and 40% debt. The loans between Calco Inc. and each of its subsidiaries reflect arms length terms and they these loans are not entered into for tax avoidance purposes. (Calco Inc. and its subsidiaries, until 2001, filed state tax returns only in California, and filed on a unitary basis in that state.)
In 2001, Calco acquires a restaurant in Massachusetts, which it will operate through a new subsidiary, Masscorp. Calco Inc. capitalizes Masscorp, the same way it has always capitalized its California subsidiaries. Calco executives realize at the time that Masscorp is funded that this capital structure will potentially give rise to a tax benefit, because the interest expense may be deductible in Massachusetts and the interest income will be eliminated in the California unitary return. However, the loan with Masscorp is not entered into for tax purposes because the same structure would have been used in the absence of a tax benefit. There are no other circumstances suggesting that the loan should be recharacterized as a capital contribution. Further, Masscorp uses the loan funds in its business and makes regular payments on the loan in accordance with the loan terms. The Commissioner will not add back Masscorp's interest expense because disallowing the deduction would be unreasonable in these circumstances. (Note that notwithstanding this example, the Commissioner will determine what is an appropriate debt-equity ratio for all Massachusetts tax purposes on a case-by-case basis, taking into account all relevant facts and circumstances.)
2. 2002 Tax Year Filings Made Prior to the Issuance of this TIR
In any case in which a taxpayer is subject to a statutory add back for its 2002 taxable year and has filed its tax return for that year prior to the date of the issuance of this TIR, the following rules apply. In all such cases, the taxpayer must submit a completed Schedule in the form of an amended return within nine months of the date of this TIR. If the taxpayer fails to meet this deadline, the Commissioner may presume that the taxpayer is unable to establish that the application of the statutory add back is unreasonable.
In general, the Commissioner will process Schedules that are filed as an amended return for a taxpayer's 2002 tax year in the same manner described above for filings that are made subsequent to the date of this TIR. When the taxpayer's amended return for its 2002 tax year includes a Schedule that asserts a Part 1 exception, the Commissioner will presume that the exception is warranted at the time of the taxpayer's filing, if this presumption would apply under the rules stated above. When the taxpayer's amended return for its 2002 tax year includes a Schedule that asserts a Part 2 exception, the Commissioner will evaluate the reasonableness of the asserted exception using the same analysis that is described for Part 2 filings above.
3. Requests for Additional Information; Procedure for Evaluating an Add Back Exception Claim
When a taxpayer claims an exception to an add back provision on its tax return without filing the Schedule as required by this TIR, the Commissioner will notify the taxpayer that it has filed an incorrect or insufficient return. When a taxpayer claims an exception to an add back provision using the Schedule, the Commissioner may request additional information or evidence in addition to that provided if he determines that this additional submission would be necessary or helpful to evaluate the taxpayer's asserted add back claim. If the taxpayer fails to respond to such request to provide this information or evidence, the Commissioner will notify the taxpayer that it has filed an incorrect or insufficient return.
In cases in which the Commissioner does not accept a taxpayer's add back claim, either as filed or subsequent to the submission of additional requested information or evidence, the Commissioner will assess additional tax. In these cases, the Commissioner will send a Notice of Intention to Assess to the taxpayer and afford the taxpayer an opportunity for a hearing, as provided under chapter 62C, section 26(b).
4. Requests for Alternative Apportionment
Sections 31I and 31J provide that in certain instances there may be an exception to the statutory add back when the taxpayer and the Commissioner agree in writing that the taxpayer may use an alternative method of apportionment pursuant to chapter 63, section 42. See G.L. c. 63, §§ 31I(c)(i), 31J(a ), added by St. 2003, c. 4, § 17. In these cases, the fact that the Commissioner grants relief under section 42 will not, by itself, entitle the taxpayer to an exception to the add back provisions. Rather, the Commissioner will determine on a case by case basis whether such an exception is appropriate, taking into account the nature of the section 42 relief granted and the purposes underlying both section 42 and the add back provisions of sections 31I and 31J.
B. Tax Years Beginning Prior to January 1, 2002: Inter-affiliate Intangible and Interest Expenses and Costs and the Requirement that a Taxpayer Prove a Valid Business Purpose and Economic Substance
The following discussion applies to inter-affiliate intangible and interest deductions asserted for tax years beginning prior to January 1, 2002, i.e., prior to the effective date ofnewly-enacted chapter 63, sections 31I and 31J. In particular, the following discussion explains the Commissioner's response to the Supreme Judicial Court's decisions in The Sherwin-Williams Company v. Comm'r, 438 Mass. 71 (2002), rehearing denied (Feb. 28, 2003) and Syms Corp. v. Comm'r, 436 Mass. 502 (2002), as considered in light of the recent legislation.
In Sherwin-Williams and Syms, the Supreme Judicial Court reached different results using different analyses on similar facts relating to an asserted inter-affiliate royalty deduction. The differing decisions in Syms and Sherwin-Williams generated uncertainty concerning the standard to be applied in similar cases. The recent legislation states that the Legislature's "original intention" as embodied in the state's tax laws is that a taxpayer seeking to claim a tax benefit in connection with a transaction must show "a valid, good-faith business purpose, other than tax avoidance" as well as "economic substance apart from the asserted tax benefit." St. 2003, c. 4, § 84. See also St. 2003, c. 4, § 87 (noting the Commissioner's authority, even prior to the date of the recent legislation, to "adjust taxpayer transactions for want of an adequate business purpose").
For tax years beginning before January 1, 2002, therefore, the Commissioner will require that a taxpayer seeking a deduction for an inter-affiliate interest or intangible cost or expense must prove that its transaction is supported by a valid business purpose other than tax avoidance and also economic substance. See Syms, 436 Mass. at 511 (noting that in cases of this nature "the taxpayer bears the burden of proof in the abatement process"). In general, the Commissioner's approach to these cases and the evidence that he will require are similar to the approach and the evidence outlined in the first part of this TIR, relating to newly-enacted chapter 63, sections 31I and 31J.
C. Use of Intangibles in Massachusetts as Establishing Nexus
An out-of-state corporation that receives trademark royalties or similar intangible receipts in connection with in-state sales is subject to the corporate excise in connection with these sales. See Directive 96-2. See also G.L. c. 63, § 39 (a foreign corporation is subject to this state's tax jurisdiction when it owns property in the state or is doing business here). Therefore, in any case in which a taxpayer contends that its intangible payments to a related member are bona-fide, the Commissioner may seek to impose tax on the related member pursuant to Directive 96-2, assuming that the provisions of that Directive otherwise apply.
/s/ Alan LeBovidge
Alan LeBovidge
Commissioner of Revenue
AL:LEM:mtf
ENDNOTES:
1. See Overnite Transportation Co. v. C'mmr, 54 Mass. App. Ct. 180 (Ct. App. 2002).[return to text]
2 This component of Part 1 might be implicated if, for example, the related member is receiving trademark or similar intangible receipts from the taxpayer in connection with in-state sales and therefore is filing a corporate excise return with Massachusetts. See Directive 96-2.[return to text]
3. The standards referenced in this and the preceding sentence are also referenced in chapter 62C, section 3A, which was enacted with sections 31I and 31J as part of the recent legislation. See St. 2003, c. 4, § 10. See also St. 2003, c. 4, §§ 84, 87 (similarly referencing these standards). [return to text]
4. See also Stone v. Essex County Newspapers, Inc., 367 Mass. 849, 871 (1975) (the "clear and convincing" standard is a heightened standard that has been construed to mean "a degree of belief greater than the usually imposed burden of proof by a fair preponderance of the evidence"; the standard requires proof that is "strong, positive and free from doubt") (quotes omitted); Tosti v. Ayik, 394 Mass. 482, 493 n. 9 (1985) (similar language). [return to text]
5. In cases in which the related member is subject to tax in more than one jurisdiction, its effective rate of tax shall be the sum of its post-apportionment rates from those jurisdictions. [return to text]
September 19, 2003
TIR 03-19