Exceptions to Interest Addback Requirements for Related ... · Exceptions to Interest Addback Requirements for Related-Member Interest and Intangible Expenses by Michael A. Guariglia,

Exceptions to Interest AddbackRequirements for Related-MemberInterest and Intangible Expenses

by Michael A. Guariglia, David J. Shipley, and Open Weaver Banks

As more states enact interest and intangibleexpense addback provisions, the statutory excep-tions to these provisions have become more varied.1Although the exceptions have some common themes,the specific exceptions contained in any state’s stat-ute are a unique combination of these themes. Inthis article, we review the similarities between theexceptions to the various state addback provisionsand then analyze the exceptions on a state-by-statebasis.

Similarities Among Exceptions to AddbackProvisions

The presence of statutory exceptions to the vari-ous state interest and intangible expense addbackprovisions is a tacit recognition that these addbackprovisions are blunt instruments of state tax policy.Under the addback provisions, all interest or intan-gible expenses paid to a related member are addedback, regardless of whether the transactions thatgenerated those expenses are legitimate related-member transactions.2 The statutory exceptions arethe states’ attempts to cure the intrinsic overreachof the addback provisions.

The presence of statutoryexceptions to the state interestand intangible expense addbackprovisions is a tacit recognitionthat these addback provisions areblunt instruments of state taxpolicy.

The exceptions to the addback provisions identifyspecific transactions with related members that areconsidered legitimate and then exclude the expensesgenerated as a result of these transactions from theamounts required to be added back to the taxpayer’staxable income. States generally use the same char-acteristics to identify legitimate related-membertransactions. These characteristics include whether:1) the related member is subject to tax in anotherjurisdiction; 2) the related member acts as a conduitin paying the interest or intangible expenses to an

1In this article, we use the term ‘‘interest and intangibleexpenses’’ generally to refer to the two types of addbackprovisions that states have enacted. The most widely enactedaddback provisions address intangible and related interestexpenses paid to related members. See, e.g., N.Y. Tax Lawsection 208(9)(o)(2)(a), Miss. Code Ann. section 27-7-17(2),and Va. Code Ann. section 58.1-402(B)(8)(a) and (B)(9)(a).Other states have enacted broad addback provisions thatinclude intangible and intangible-related interest expenses aswell as all other (nonintangible) interest expenses paid torelated members. See, e.g., Md. Tax Gen. section 10-306.1.Finally, some states have enacted addback provisions thataddress intangible and related interest expenses and sepa-rate addback provisions that address all other (nonintangible)interest paid to related members. See, e.g., Mass. Gen. Lawsch. 63 section 31I and Mass. Gen. Laws ch. 63 section 31J(a).Additionally, Kentucky has enacted a provision that requiresan addback of related member management fees. See Ky. Rev.Stat. Ann. section 141.205(4).

2Most states use the term ‘‘related member’’ to identifyanother entity that controls the taxpayer, is controlled by thetaxpayer, or is under common control with the taxpayer. See,e.g., Md. Tax Gen. section 10-306.1(a)(9) and Miss. Code Ann.section 27-7-17(b)(2)(a)(iv).

Michael A. Guariglia, David J. Shipley, and OpenWeaver Banks are members of McCarter & English LLP’smultistate tax group. Guariglia is a partner in McCarter &English’s Newark, N.J. office; Shipley is special counsel inMcCarter & English’s Philadelphia office; and Banks is anassociate in McCarter & English’s Newark office.

This article was adapted from a presentation at the May2005 Georgetown Advanced State and Local Tax Institute.

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unrelated third party; 3) the related-member trans-action has a valid nontax business purpose; and 4)the related-member transaction is at an arm’s-length consideration. Many states have also enacteda catchall exception for cases in which the addbackotherwise would be ‘‘unreasonable.’’ In addition tothe exceptions based on the common characteristicsof legitimate related-member transactions, somestates have exceptions that are truly unique.

Many states recognize an exception for paymentsto a related member when the related member issubject to tax in the state requiring the addback orsubject to tax in another state during the same taxyear in which the taxpayer claims the interest orintangible expense deduction.3 The requirementthat the related member be subject to tax in anotherstate generally means that the related member issubject to an income tax in the other state and thatthe interest or intangible income is included in therelated member’s taxable income reported to thatstate.4 For some states, merely being subject to a taxin another state is not sufficient to avoid the add-back provisions. Those states require the taxpayerto demonstrate that the related member’s income issubject to tax at a threshold rate, often determinedby reference to the tax rates of the states requiringthe addback.5

Additionally, some states permit an exclusionfrom the addback provisions only to the extent thatthe income resulting from the interest or intangiblepayment is included in the related member’s post-apportionment income of another state.6 Under sucha provision, if 5 percent of the related member’sincome is included in the post-apportionment tax-able income in another state, 95 percent of theexpense deduction would be required to be addedback.

States also provide an exception to the interestand intangible addback provisions for interest orintangible expenses paid to a related member that isorganized under the law of a foreign jurisdiction andsubject to a comprehensive income tax treaty be-

tween that foreign jurisdiction and the UnitedStates.7 New York qualifies that exception by requir-ing that the payments to the related member betaxed by the foreign jurisdiction at a rate at leastequal to the tax rate imposed by New York.8

Although some states do not have a specific ex-ception for income subject to tax in another jurisdic-tion, a taxpayer may be able to establish that theaddback is ‘‘unreasonable’’ based on the resultingdouble taxation.9

State addback provisions frequently provide anexception for payments to a related member whenthe related member is acting as a conduit by payingthe interest or intangible expense to an unrelatedthird party during the same tax year.10 Many stateslimit that exception to transactions that are atarm’s-length consideration or transactions thathave a valid business purpose.11 New Jersey limitsthe exception for interest payments to an indepen-dent lender to instances when the taxpayer legallyguarantees the debt on which the interest is paid.12

Many states require a taxpayer to demonstratethat a related-member transaction has a businesspurpose other than tax avoidance. Virginia is theonly state that provides an exception based solely ona determination that the underlying transaction didnot have a tax avoidance motive.13 Alabama andMississippi do not require an addback for paymentsresulting from transactions that do not have theavoidance of the respective state’s taxes as a princi-pal purpose, provided that the related member is notprimarily engaged in the management of intangible

3See, e.g., Ala. Code section 40-18-35(b)(1), Ga. Code Ann.section 48-7-28.3(d)(2), and Md. Tax Gen. section 10-306(c).

4See, e.g., Ala. Code section 40-18-35(b)(1) and Ala. Admin.Code 810-3-35-.02, which defines ‘‘subject to tax based on ormeasured by the related member’s net income’’ to require thatthe receipt of the payment by the related member be reportedand included in income for purposes of a tax on net incomeand not offset or eliminated in a combined or consolidatedreturn.

5See, e.g., Md. Tax Gen. section 10-306.1(c)(3)(ii)3 (effectivetax rate of 4 percent), Mass. Gen. Laws ch. 63 section 31J(b)(Massachusetts tax rate less 3 percentage points), and N.J.Stat. Ann. section 54:10A-4(k)(2)(I) (New Jersey tax rate less3 percentage points).

6See, e.g., Ala. Code section 40-18-35(b)(1) and Ala. Admin.Code 810-3-35-.02(3)(g).

7See, e.g., Ala. Code section 40-18-35(b)(1); 2003 Conn.Pub. Acts 6, section 78(e); and Ga. Code Ann. section 48-7-28.3(e)(1).

8See N.Y. Tax Law section 208(9)(o)(1)(D).9See, e.g., N.J. Admin. Code section 18:7-5.18(b)3, which

recognizes that the addback of intangible expenses would beunreasonable to the extent that the payee pays New Jerseycorporation business tax on the income stream, and Massa-chusetts Technical Information Release 03-19, which providesthree specific instances in which double taxation would beunreasonable.

10See, e.g., Miss. Code Ann. section 27-7-17(2)(c)(i), N.Y.Tax Law section 208(9)(o)(2)(B)(i), and Va. Code Ann. section58.1-402(B)(8)(a)(2).

11See, e.g., N.J. Stat. Ann. section 54:10A-4.4(c)(3), whichonly excludes conduit payments when the transaction givingrise to the intangible expenses did not have as a principalpurpose the avoidance of New Jersey corporation business taxor gross income tax, and N.Y. Tax Law section 208(o)(2)(B)(i),which excludes conduit payments for transactions done for avalid business purpose and at an arm’s-length consideration.

12N.J. Stat. Ann. section 54:10A-4(k)(2)(I).13See Va. Code Ann. section 58.1-402(B)(8)(b), which per-

mits an exception from the addback provisions if the corpo-ration can demonstrate to the commissioner’s ‘‘sole satisfac-tion, by clear and convincing evidence’’ that the transactionhad a valid business purpose other than the ‘‘avoidance orreduction of tax.’’

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property or financing of related entities.14 Moststates with addback provisions require an analysisof the business purpose of the underlying transac-tion generating the interest or intangible expensesas a condition to qualify for another exception.15

Most states with addbackprovisions require an analysis ofthe business purpose of theunderlying transaction as acondition to qualify for anotherexception.

The business purpose requirements in the vari-ous addback provisions generally fall into two cat-egories: 1) the taxpayer must establish that therewas a primary business purpose for the transactiongenerating the expense deduction other than taxavoidance; and 2) the taxpayer must establish thattax avoidance was not a primary business purposefor the transaction generating the expense deduc-tion.16 Although the two tests initially may appearsimilar, the difference between the two tests isapparent in the case of a taxpayer that has twoprimary business purposes for entering into a trans-action in which the first primary business purpose isa legitimate nontax business purpose and the secondprimary business purpose was tax-motivated. Sucha transaction would pass the first test because one ofthe taxpayer’s primary business purposes was nottax avoidance, but would fail the second test becauseone of the taxpayer’s primary business purposes wastax-motivated. Many of the exceptions based onbusiness purpose define a tax avoidance business

purpose solely in terms of avoiding the tax of thestate imposing the addback requirement.17

In many instances, states require a taxpayer todemonstrate that any related-member transactionsare conducted based on arm’s-length terms andconsideration. No state provides an exception solelyon the basis that a transaction is at an arm’s-lengthconsideration. Rather, the arm’s-length consider-ation concept is included as one of the conditions toqualify for another exception to the addback provi-sions.18

States also provide exceptions when the taxpayeris subject to a discretionary adjustment of income orapportionment factors, often based on a writtenagreement with the relevant taxing authority.19

Those provisions make sense when the taxpayersand taxing authorities are agreeing to adjustmentsto the tax base and the apportionment factors thatresult in the proper reflection of income fromrelated-member transactions. However, those provi-sions do not make sense when the exceptions ad-dress only the use of alternative methods of appor-tionment.20 It is difficult to imagine a set ofcircumstances in which merely adjusting a taxpay-er’s apportionment factor would obviate the need foran addback of interest or intangible expenses.21

The corollary to the exception for taxpayers thatenter into a written agreement with the taxingauthority regarding adjustments to the taxpayer’sincome or apportionment factors is the taxing au-thority’s reservation of the ability to make discre-tionary adjustments regarding a taxpayer’s incomeand apportionment factors.22 Such provisions ap-pear to be included due to an abundance of caution,

14Ala. Code section 40-18-35(b)(3) and Miss. Code. Ann.section 27-7-17(2)(c)(ii).

15See, e.g., Ga. Code Ann. section 48-7-28.3(e)(1), whichpermits an exception for payments to a foreign related mem-ber provided that there is a valid business purpose and anarm’s-length rate of consideration, and Ohio R.C. section5733.042(D)(2), which provides an exception for expensespaid to a related member when that related member pays theamount received to an unrelated third party provided that thetransaction giving rise to the expenses did not have as aprincipal purpose the avoidance of Ohio tax.

16Compare the language of N.J. Stat. Ann. section 54:10A-4.4(c)(3), which excludes certain intangible expenses from theaddback provision provided that the underlying related partytransaction ‘‘did not have as a principal purpose the avoid-ance of any portion’’ of the corporation business tax or grossincome tax, and N.J. Stat. Ann. section 54:10A(4)(k)(2)(i),which excludes certain interest expenses from the addbackprovision if the taxpayer can demonstrate that ‘‘a principalpurpose of the [underlying related party] transaction’’ was notto avoid New Jersey corporation business tax.

17See, e.g., Ark. Code Ann. section 26-51-423(g)(1)(B), Md.Tax Gen. section 10-306.1(c), (d)(1), and Va. Code Ann. section58.1-402(B)(8)(a)(3).

18See, e.g., Ark. Code Ann. section 26-51-423(g)(1)(B),which excepts the payment of interest and intangible ex-penses paid under an arm’s-length contract or arm’s-lengthrate of interest when the related-party transaction was notintended to avoid the payment of Arkansas tax, and N.Y. TaxLaw section 208(9)(0)(2)(A), which provides an exception forpayments by the related party to an unrelated member ifthere is a valid business purpose and the payments to therelated party are at an arm’s-length consideration.

19See, e.g., Ohio R.C. section 5733.042(D)(1)(b).20See, e.g., Conn. Gen. Stat. section 12-218c(1), N.J. Stat.

Ann. section 54:10A-4(k)(2)(I), N.J. Stat. Ann. section 54:10A-4.4(c)(1)(c), and Ky. Rev. Stat. Ann. section 141.205(3)(d).

21It would appear that the written agreement exception asoriginally enacted by Ohio lost something in translation whenthat exception was replicated by Connecticut, New Jersey,and other states.

22See, e.g., Mass. Gen. Laws ch. 63 section 31I(c)(1), Mass.Gen. Laws ch. 63 section 31J(d), and Va. Code Ann. section58.1-402(B)(8)(c).

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because there is nothing inherent in the addbackprovisions that would otherwise preclude a state’suse of those discretionary adjustment provisions.

Additionally, many of the addback provisions con-tain exceptions for situations in which the taxpayercan demonstrate that the addback of interest andintangible expenses paid to a related party is unrea-sonable.23 However, little guidance has been pro-vided by states as to what would constitute an‘‘unreasonable’’ application of the addback provi-sions.24 When guidance has been provided, stateshave generally found many of the exceptions in-cluded in other states’ addback provisions to be areasonable interpretation of what is unreasonable.25

Little guidance has been providedby states as to what wouldconstitute an ‘unreasonable’application of the addbackprovisions.

Finally, there are some exceptions to the addbackprovisions that are unique. Arkansas has an excep-tion for interest and intangible expenses paid torelated members that have substantial operations ina ‘‘nontax location.’’26 Connecticut and Ohio haveexceptions to the extent that the increased taxattributable to the addback provisions would havebeen avoided if the taxpayer and the related mem-ber filed a combined return.27 Kentucky has anexception that applies when both the corporationpaying the expense and the related party are in-cluded in the same consolidated Kentucky corpora-tion income tax return. The most unique exceptionto an addback provision belongs to Tennessee, whichpermits a deduction of intangible expenses paid to arelated member to the extent that the taxpayerproperly discloses the transaction on its Tennessee

tax return.28 Unfortunately, it is doubtful that otherstates will adopt such a taxpayer-friendly exception.

The Exceptions — State by State

Alabama

A. General RuleIn Alabama, corporations are required to add

back otherwise deductible interest expenses andcosts and intangible expenses and costs directly orindirectly paid, accrued, or incurred to, or in connec-tion with one or more direct or indirect transactions,with one or more related members, unless one of fiveexceptions applies.29

B. Exceptions

1. Related Member’s Income Subject to Taxin Alabama or Other StateThe addback provision does not apply to the

extent the corporation shows, upon request by thecommissioner, that the corresponding item of incomewas, in the same taxable year, subject to a tax basedon or measured by the related member’s net incomein Alabama or any other state of the United States.30

‘‘Subject to a tax based on or measured by therelated member’s net income’’ means that the receiptof the payment by the related member is reportedand included in income for purposes of a tax on netincome, and not offset or eliminated in a combined orconsolidated return that includes the payer.31 ‘‘Re-ported and included in income for purposes of a taxon net income’’ means reported and included inpost-allocation and post-apportionment income forpurposes of a tax applied to the net income appor-tioned or allocated to the taxing jurisdiction.32

The subject-to-tax exception is allowed only to theextent the related member includes the correspond-ing item of income in post-allocation and post-apportionment income reported to the taxing juris-diction.33 That is, if 5 percent of the correspondingincome is taxed in another state, 95 percent of theintangibles or interest payment is subject to theaddback.

The corporation must establish, to the Depart-ment of Revenue’s satisfaction, in a writing attachedto the return, that it qualifies for the exceptionbased on the corresponding income being subject totax in Alabama or another state.34

23See, e.g.,Ala.Codesection40-18-35(b)(2),Conn.Gen.Stat.section 12-218c(1), and Ohio R.C. section 5733.042(D)(1)(a).

24Only Massachusetts and New Jersey have provided anyguidance as to what would be ‘‘unreasonable.’’ See Massachu-setts Technical Information Release 03-19 and N.J. Admin.Code section 18:7-5.18(b)3.

25See Massachusetts Technical Information Release 03-19and N.J. Admin. Code section 18:7-5.18(b)3, which generallyprovide that an addback would be unreasonable if it results inactual double taxation. The Massachusetts technical informa-tion release also provides that a taxpayer must establish thatthe transaction at issue was entered into for a valid businesspurpose, supported by economic substance and at an arm’s-length consideration, to be eligible for the ‘‘unreasonable’’exception.

26Ark. Code Ann. section 26-51-423(g)(1)(D).27Conn. Gen. Stat. section 12-218c(3); Ohio R.C. section

5733.042(D)(4).

28Tenn. Code Ann. section 67-4-2006(b)(2)(O).29Ala. Code section 40-18-35(b)(1).30Ala. Code section 40-18-35(b)(1).31Ala. Code section 40-18-35(b)(1); Ala. Admin. Code 810-

3-35-.02(3)(e).32Ala. Admin. Code section 810-3-35-.02(3)(f).33Ala. Admin. Code section 810-3-35-.02(3)(g).34Ala. Admin. Code section 810-3-35-.02(2)(d).

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2. Foreign Related MemberWith Income Tax TreatyThe addback provision does not apply to the

extent the corporation shows, upon request by thecommissioner, that the corresponding item of incomewas, in the same taxable year, subject to a tax basedon or measured by the related member’s net incomeby a foreign nation, which has in force an income taxtreaty with the United States, if the recipient was a‘‘resident’’ (as defined in the income tax treaty) of theforeign nation.35 The same definitions and qualifica-tions applicable to the exception for income taxed inAlabama or other states also apply to the treatynation exception.

The corporation must establish, to the depart-ment’s satisfaction, in a writing attached to thereturn, that it qualifies for the exception for incomesubject to tax in a treaty nation.36

3. UnreasonableThe Alabama addback provision does not apply if

the corporation establishes that the addback adjust-ments are unreasonable.37 The adjustments will beconsidered unreasonable if the taxpayer establishes,based on the entirety of the taxpayer’s particularfacts and circumstances, that the adjustments haveincreased the taxpayer’s Alabama income tax liabil-ity to an amount that bears no fair relation to thetaxpayer’s Alabama presence.38 The corporationmust establish the unreasonableness of the addbackadjustments in a written statement attached to thecorporation’s Alabama corporate income tax re-turn.39

4. Written AgreementThe addback provision does not apply if the cor-

poration and the commissioner agree in writing tothe application or use of alternative adjustmentsand computations.40

Requests for alternative adjustment agreementsshould be directed to the Alabama revenue commis-sioner and submitted in writing to the DOR at least10 weeks prior to the filing of the taxpayer’s corpo-rate income tax return for which the agreement isrequested.41 The request should describe both thetaxpayer’s particular facts and circumstances thatwarrant an alternative adjustment and the terms ofthe proposed alternative adjustment. If the taxpayeris unable to submit the request 10 weeks beforefiling of the return, the taxpayer is required to pay

the tax in full and request a refund as part of itsrequest for an alternate adjustment agreement.

5. No Principal Purpose to Avoid Tax andRelated Member Not an Intangible HoldingCompanyThe Alabama addback provision does not apply to

interest expenses and costs and intangible expensesand costs if the corporation can establish (i) that thetransaction giving rise to the interest expenses andcosts or the intangible expenses and costs betweenthe corporation and the related member did not haveas a principal purpose the avoidance of any Alabamatax and (ii) the related member is not ‘‘primarilyengaged’’ in the acquisition, use, licensing, mainte-nance, management, ownership, sale, exchange, orany other disposition of intangible property, or in thefinancing of related entities.42

If the transaction giving rise to the expenses andcosts has a substantial business purpose and eco-nomic substance and contains terms and conditionscomparable to a similar arm’s-length transactionbetween unrelated parties, the transaction will bepresumed to not have as its principal purpose taxavoidance, subject to rebuttal by the commissioner.43

‘‘Primarily engaged’’ means that as a percentageof total receipts, receipts from the specified intan-gible activities or the receipts from financing relatedentities exceed the receipts from any other readilyidentifiable category of receipts.44 For purposes oftesting the percentage of total receipts, the regula-tions require that categories of other readily identi-fiable receipts may not be combined.45 That is,receipts for sales of goods may not be combined withreceipts from repairs of goods, for purposes of deter-mining whether the percentage of receipts fromintangible or financing activities exceeds the re-ceipts from any other readily identifiable category ofreceipts.46 Furthermore, Schedule AB to the Ala-bama tax return provides that receipts of a disre-garded entity/subchapter K entity may not be com-bined with receipts of its owner.

The corporation must establish, to the commis-sioner’s satisfaction, in a writing attached to itsreturn, that it qualifies for the principal purposeexception.47 Schedule AB contains a section for cor-porations to provide information about their relatedmembers’ intangible and interest receipts and othercategories of receipts.

Schedule AB further requires that for a taxpayerto qualify for the principal purpose exception, an

35Ala. Code section 40-18-35(b)(1).36Ala. Admin. Code section 810-3-35-.02(2)(d).37Ala. Code section 40-18-35(b)(2).38Ala. Admin. Code section 810-3-35-.02(3)(h).39Ala. Admin. Code section 810-3-35-.02(2)(a).40Ala. Code section 40-18-35(b)(2).41Ala. Admin. Code section 810-3-35-.02(3)(i).

42Ala. Code section 40-18-35(b)(3).43Ala. Code section 40-18-35(b)(1).44Ala. Admin. Code section 810-3-35-.02(3)(b).45Ala. Admin. Code section 810-3-35-.02(3)(b)1.46Ala. Admin. Code section 810-3-35-.02(3)(b)1.47Ala. Admin. Code section 810-3-35-.02(2)(c).

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informed corporate officer must sign the statementunder penalties of perjury; and the transactionsgiving rise to the expenses, and any prior organiza-tional restructuring transactions that facilitatedsuch transactions, must not have tax avoidance(which includes the avoidance of a meaningfulamount of Alabama tax) as a principal motivatingfactor. The instructions to Schedule AB state that ifthe related member is not primarily engaged in thefinancing of related members and the managementof intangibles, it qualifies for only part of the prin-cipal purpose exception. In order to qualify for theexception in full, the corporation must also providethe signature of the informed corporate officer at-testing to the lack of a tax avoidance motive.

Arkansas

A. General RuleArkansas requires an addback of interest or

intangible-related expenses paid by the taxpayer toa related party.48

B. Exceptions

1. Related Member’s Income Subject to Taxin Arkansas, Another State, or a ForeignCountry With a Tax TreatyArkansas does not require an addback of interest

or intangible-related expenses paid to a relatedparty if the interest or intangible-related incomereceived by the related party is subject to an incometax imposed by Arkansas, another state, or a foreigngovernment that has entered into a comprehensiveincome tax treaty with the United States.49

2. Transactions at Arm’s-LengthConsideration and Not Intended to AvoidArkansas TaxArkansas does not require an addback of interest

and intangible-related expenses paid to a relatedparty if the interest and intangible-related incomewas received under an arm’s-length contract or at anarm’s-length rate of interest and the related-partytransaction was not intended to avoid the paymentof Arkansas income tax otherwise due.50

3. Written AgreementArkansas does not require an addback of interest

and intangible-related expenses paid to a relatedparty if the taxpayer and the director of finance andadministration enter into a written agreement be-fore the due date of the taxpayer’s Arkansas incometax return.51 That agreement must either authorizethe taxpayer to take the deduction for the tax years

at issue or require the use of an alternative appor-tionment method for the tax years at issue.52

4. Substantial OperationsIn a ‘Nontax Location’Arkansas does not require an addback of interest

and intangible-related expenses paid to a relatedparty if the related-party recipient of the interest orintangible-related income has substantial opera-tions in a ‘‘nontax location.’’53 A nontax location isdefined as a state or foreign country where therelated party is not subject to an income tax.54 Toqualify for the exception from the addback, therelated party must: 1) operate an active trade orbusiness in the nontax location; 2) have a minimumof 50 full-time-equivalent employees in the nontaxlocation; 3) own real or tangible personal propertywith a fair market value in excess of $1 millionlocated in the nontax location; and 4) have revenuesgenerated from sources within the nontax locationin excess of $1 million.55

Connecticut — Related-Member Intangibleand Related Interest Expenses

A. General RuleFor purposes of computing its Connecticut net

income, a corporation must add back otherwisedeductible intangible and related interest expensesand costs directly or indirectly paid, accrued orincurred to, or in connection with one or more director indirect transactions with one or more relatedmembers.56

B. Exceptions

1. UnreasonableThe Connecticut addback provision does not ap-

ply if the corporation establishes by clear and con-vincing evidence that the adjustments are unreason-able.57

2. Written AgreementThe Connecticut addback provision does not ap-

ply if the corporation and the commissioner of rev-enue services agree in writing to the application oruse of an alternative method of apportionment un-der Conn. Gen. Stat. section 12-221a.58

3. No Principal Purpose to Avoid Tax andPayment to Unrelated MemberThe Connecticut addback does not apply to such

portion of interest expenses and costs and intangible

48Ark. Code Ann. section 26-51-423(g)(1).49Ark. Code Ann. section 26-51-423(g)(1)(A).50Ark. Code Ann. section 26-51-423(g)(1)(B).51Ark. Code Ann. section 26-51-423(g)(1)(C).

52Ark. Code Ann. section 26-51-423(g)(1)(C)(i) and (ii).53Ark. Code Ann. section 26-51-423(g)(1)(D).54Ark. Code Ann. section 26-51-423(g)(1)(D).55Ark. Code Ann. section 26-51-423(g)(1)(D)(i), (ii), (iii).56Conn. Gen. Stat. section 12-218c(b).57Conn. Gen. Stat. section 12-218c(c)(1).58Conn. Gen. Stat. section 12-218c(c)(1).

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expenses and costs that the corporation can estab-lish by a preponderance of the evidence meets bothof the following:

(A) The related member during the same in-come year directly or indirectly paid, accruedor incurred such portion to a person who is nota related member, and

(B) The transaction giving rise to the interestexpenses and costs or the intangible expensesand costs between the corporation and therelated member did not have as a principalpurpose the avoidance of any portion of the taxdue under Connecticut Chapter 208.59

4. Combined Reporting

The Connecticut addback provision does not ap-ply to the extent that the increased tax, if any,attributable to such adjustments would have beenavoided if both the corporation and the relatedmember had been eligible to make and had timelymade the election to file a combined return underConn. Gen. Stat. section 12-223a(a).60

Connecticut — Related-Member InterestExpense

A. General Rule

For purposes of computing its Connecticut netincome, a corporation must add back otherwisedeductible interest expenses and costs directly orindirectly paid, accrued or incurred to, or in connec-tion directly or indirectly with one or more direct orindirect transactions with one or more related mem-bers.61

B. Exceptions

The Connecticut Department of Revenue Servicesrequires all interest expenses and costs subject tothe addback to be added back before claiming anexception to the addback.62

1. No Principal Purpose to Avoid Tax,Arm’s-Length Interest, and Related MemberSubject to Tax at Threshold Rate

The Connecticut interest addback does not applyto an otherwise deductible interest expense or cost ifthe corporation establishes by clear and convincingevidence, as determined by the commissioner, that:

(1) a principal purpose of the transaction givingrise to the payment of interest was not to avoidpayment of taxes due;

(2) the interest is paid under a contract thatreflects an arm’s-length rate of interest andterms; and

(3) either

(A) (i) the related member was subject totax on its net income in Connecticut oranother state or possession of the UnitedStates or a foreign nation; (ii) a measureof said tax included the interest receivedfrom the corporation; and (iii) the rate oftax applied to the interest received by therelated member is no less than the statu-tory rate of tax applied to the corporationunder section 12-214 of the Connecticutgeneral statutes minus 3 percentagepoints,

or

(B) the related member is a companysubject to tax under chapter 207 of thegeneral statutes (insurance companies,hospital and medical services corpora-tions taxes) or comparable tax under thelaws of another state.63

The rate of tax is determined by dividing theamount of tax actually paid (after credits are ap-plied) by the taxable income before apportionmentand application of operating loss carryforwards.64

The Connecticut Department of Revenue Servicestakes the position that this exception does not applyto transactions with a related member when therelated member files in another jurisdiction with thecorporation on a combined, consolidated, or unitarybasis when the interest expense of the taxpayer andthe interest income of the related member is offset oreliminated.65 In the case of interest paid to a relatedmember that files a return with the corporation in ajurisdiction on a combined, consolidated, or unitarybasis, the interest income reported by the relatedmember is eliminated and thus not taxed.66 Simi-larly, this exception does not apply to interest ex-penses and costs that are paid to a related memberwhen the related member has a net operating loss orpays tax on a basis other than net income including,but not limited to, a gross receipts tax, capital basetax, or a business and occupational tax.67 When theinterest expenses and costs are paid to a relatedmember that has a net operating loss or the relatedmember is taxed on a basis other than net income,the statutory requirement that the related memberwas subject to tax on its net income in this state or

59Conn. Gen. Stat. section 12-218c(c)(2).60Conn. Gen. Stat. section 12-218c(c)(3).612003 Conn. Pub. Acts 6, section 78(b).62Special Notice 2003(22) at p. 1.

632003 Conn. Pub. Acts 6, section 78(c).64Special Notice 2003(22) at p. 2.65Special Notice 2003(22) at p. 2.66Id.67Id.

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another state, a possession of the United States, or aforeign nation is not met.68

2. UnreasonableThe interest addback does not apply if the corpo-

ration establishes by clear and convincing evidence,as determined by the commissioner, that the adjust-ments are unreasonable.69 Connecticut Form CT-1120AB does not address the unreasonableness ex-ception. To claim that exception, the corporationshould submit a petition in writing to the commis-sioner, before filing its return for the year in whichthe exception is claimed.70 The petition must setforth the applicable facts and provide clear andconvincing evidence that the addback is unreason-able. The commissioner will grant or deny approvalof the use of this exception. Clear and convincingevidence is evidence that is so ‘‘clear, direct, andweighty’’ that it will permit the commissioner to‘‘come to a clear conviction without hesitancy’’ of thevalidity of the corporation’s claim.71 The unreason-able exception may only be claimed if the corpora-tion has obtained prior written approval from thecommissioner. A copy of the commissioner’s determi-nation that an adjustment would be unreasonablemust be attached to Form CT-1120AB.

3. Written AgreementThe interest addback does not apply if the corpo-

ration and the commissioner agree in writing to theapplication or use an alternative method of deter-mining the combined measure of the tax, providedthat the commissioner of revenue services will con-sider approval of such petition only in the event thatthe petitioners have clearly established to the satis-faction of the commissioner that there are substan-tial intercorporate business transactions amongthose included corporations and that the proposedalternative method of determining the combinedmeasure of the tax accurately reflects the activity,business, income, or capital of the taxpayers withinthe state.72

To qualify for the exception a corporation mustsubmit a petition in writing for approval of analternate method 60 days before filing a combinedreturn.73

4. Election to Calculate on a Unitary BasisThe interest addback does not apply if the corpo-

ration elects, on Form CT-1120U, to calculate its taxon a unitary basis, including all members of the

unitary group provided that there are substantialintercorporate business transactions among suchincluded corporations.74 That election to file on aunitary basis shall be irrevocable for and applicablefor five successive income years.

5. Foreign Related MemberWith Income Tax TreatyThe interest addback does not apply if the inter-

est is paid to a related member located in a countrywith which the United States has a comprehensiveincome tax treaty.75

Georgia (Applicable to Tax Years Beginningon or After January 1, 2006)

A. General RuleFor purposes of computing its Georgia taxable

income, a taxpayer is required to add back otherwisedeductible interest expenses and costs and intan-gible expenses and costs directly or indirectly paid,accrued, or incurred to, or in connection directly orindirectly with one or more direct or indirect trans-actions with one or more related members.76 Theseexpenses and costs are added back before the tax-payer’s income is apportioned or allocated.

B. Exceptions

1. Written AgreementThe commissioner of revenue shall have the au-

thority to reverse in whole or in part the addbackadjustments when the taxpayer and the commis-sioner agree in writing to the application or use of analternative method of apportionment under GeorgiaCode section 48-7-31(d)(2)(E), section 48-7-35, orsection 48-7-31.1.77

2. Related Member’s Income Subject to Taxin Georgia or Other StateAnd Arm’s-Length TransactionThe amount of the addback adjustment will be

reduced, but not below zero, to the extent the corre-sponding interest expenses and costs and intangibleexpenses and costs:

(A) are received as income in an arm’s-lengthtransaction by the related member; and(B) that income is allocated or apportioned, orboth, to and taxed by Georgia or another statethat imposes a tax on or measured by theincome of the related member.78

The exception is not available if income is taxed ina state in which the taxpayer files with the related

68Id.692003 Conn. Pub. Acts 6, section 78(d).70Special Notice 2003(22) at p. 3.71Special Notice 2003(22) at p. 3, which refers to United

States v. Goba, 220 F. Supp. 2d 182, 188 (W. D.N.Y. 2002).722003 Conn. Pub. Acts 6, section 78(d).73Special Notice 2003(22) at p. 4.

742003 Conn. Pub. Acts 6, section 78(d); Special Notice2003(22) at p. 4.

752003 Conn. Pub. Acts 6, section 78(e).76Ga. Code Ann. section 48-7-28.3(b).77Ga. Code Ann. section 48-7-28.3(c).78Ga. Code Ann. section 48-7-28.3(d)(2).

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member (or the related member files with anotherrelated member) a combined income tax report orreturn, a consolidated income tax report or return,or any other report or return when such report orreturn is due because of the imposition of a tax on, ormeasured by, income and when such combined in-come tax report or return, consolidated income taxreport or return, or other report or return results inelimination of the tax effects from transactions di-rectly or indirectly between the taxpayer and therelated member.79

In claiming this exception the taxpayer mustdisclose on its return the name of the related mem-ber, the federal identification number of the relatedmember, the name of each state, the amount of theinterest expenses and costs and intangible expensesand costs allocated or apportioned to and taxed byeach state, and such other information that thecommissioner may prescribe.80

3. Foreign Related Member,Valid Business Purpose,And Arm’s-Length TransactionThe addback adjustment will be reduced, but not

below zero, if and to the extent:

(A) the interest expenses and costs and intan-gible expenses and costs are paid, accrued, orincurred to a related member domiciled in aforeign nation which has in force a comprehen-sive income tax treaty with the United States;

(B) the transaction giving rise to the interestexpenses and costs and intangible expensesand costs has a valid business purpose; and

(C) the amounts of the interest expenses andcosts and intangible expenses and costs weredetermined at arm’s-length rates.81

In claiming this exception, the taxpayer mustdisclose on its return the name and federal identifi-cation number of the related member; the amount ofthe interest expenses and costs and intangible ex-penses and costs; the country of domicile of therelated member; and other information that thecommissioner may prescribe.82

4. Unrelated MemberAnd Valid Business PurposeThe Georgia addback adjustment will not apply to

the portion of interest expenses and costs and intan-gible expenses and costs that the taxpayer estab-lishes by a preponderance of the evidence meetsboth of the following:

(A) the related member during the same taxyear directly or indirectly paid, accrued, orincurred such portion to a person that is not arelated member; and

(B) the transaction giving rise to the interestexpenses and costs and intangible expensesand costs has a valid business purpose.83

Kentucky

A. General Rule

For tax years beginning on or after January 1,2005, Kentucky corporation income taxpayers arenot permitted to deduct intangible interest expensesor management fees directly or indirectly paid torelated members and foreign corporations thatwould qualify as related members if those corpora-tions were domestic corporations.84 Although theKentucky addback statute as enacted defines ‘‘in-tangible expenses,’’ that statute does not specificallyrequire the intangible expenses to be added back.85

The Kentucky Revenue Department expects to cor-rect that legislative omission through a technicalcorrections bill. If the technical corrections bill isenacted, intangible expenses will be disallowed fortax years beginning on or after January 1, 2005, andthe exceptions to the addback of intangible expenseswill mirror the exceptions for intangible interestexpenses.

B. Intangible Interest Expense Exceptions

1. Consolidated ReturnKentucky permits a deduction for intangible in-

terest expenses paid to a related member if thetaxpayer and the related member are both includedin the same consolidated Kentucky corporation in-come tax return for the tax year in which theintangible interest expenses are paid.86

2. Related Member Subject to Tax/ForeignTax Treaty, Substantial Business Activities,and Arm’s-Length Rates and TermsCorporations can deduct intangible interest ex-

penses paid to related members if the corporationproperly discloses the related-member transactionand establishes by a preponderance of the evidencethat: 1) the related member is subject to a net

79Ga. Code Ann. section 48-7-28.3(d)(1)(B).80Ga. Code Ann. section 48-7-28.3(d)(3).81Ga. Code Ann. section 48-7-28.3(e)(1).82Ga. Code Ann. section 48-7-28.3(e)(2).

83Ga. Code Ann. section 48-7-28.3(f).84Ky. Rev. Stat. Ann. section 141.205(2) and (4).85See Ky. Rev. Stat. Ann. section 141.205(1)(a) (defining

‘‘intangible expenses’’). Additionally, compare Ky. Rev. Stat.Ann. section 141.205(2) (requiring the addback of ‘‘an intan-gible interest expense’’) and Ky. Rev. Stat. Ann. section141.205(3), providing an exception to the addback authorizedin section 141.205(2) based, in part, on the ‘‘transaction givingrise to the intangible interest expense or the intangibleexpense’’ being at arm’s-length rates and terms.

86Ky. Rev. Stat. Ann. section 141.205(3)(a).

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income tax or franchise tax (measured in whole or inpart by net income) in its state or country of com-mercial domicile, provided that for deductions ofintangible expenses paid to foreign corporations, theforeign country in which the corporation has itscommercial domicile must have a comprehensiveincome tax treaty with the United States; 2) therelated member is engaged in substantial businessactivities separate and apart from the managementof intangible property; and 3) the transaction givingrise to the expense was at a commercially reasonablerate and at terms comparable to an arm’s-lengthtransaction.87

3. Related Member Engages in IdenticalTransactions With Unrelated Parties

Intangible interest expenses are not required tobe added back if the corporation paying the expensesproperly discloses the related-member transactionand establishes by a preponderance of the evidencethat the related member regularly engages in trans-actions with one or more unrelated parties on termsidentical to those of the related-member transac-tion.88

4. Alternative Method of Apportionment

The disallowance of the deduction for related-member intangible interest charges does not apply ifthe taxpayer and the Revenue Department agree inwriting to the application of an alternative appor-tionment method under Ky. Rev. Stat. Ann. section141.120(9).89

C. Management Fees Exceptions

1. Consolidated Return

Kentucky permits a deduction for managementfees paid to a related member if the taxpayer and therelated member are both included in the sameconsolidated Kentucky corporation income tax re-turn for the tax year in which the management feesare paid.90

2. Transaction at Arm’s-Length RatesAnd Terms

A corporation is permitted to deduct managementfees paid to a related member if the corporationproperly discloses the related-member transactionand establishes by a preponderance of the evidencethat the transaction giving rise to the managementfees was at a commercially reasonable rate and atterms comparable to an arm’s-length transaction.91

3. Alternative Method of ApportionmentThe disallowance of the deduction for related-

member management fees does not apply if thetaxpayer and the Revenue Department agree inwriting to the application of an alternative appor-tionment method under Ky. Rev. Stat. Ann. section141.120(9).92

Maryland

A. General RuleFor purposes of computing its Maryland modified

income, a corporation must add back any otherwisedeductible interest expense or intangible expensethat is directly or indirectly paid, accrued or in-curred to, or in connection with one or more direct orindirect transactions with one or more related mem-bers.93 Intangible expenses include any expensesrelated to or in connection with, directly or indi-rectly, the use, maintenance, management, owner-ship, sale, exchange, or any other disposition ofintangible property.94 Intangible expenses also in-clude a loss related to or incurred in connectiondirectly or indirectly with factoring transactions ordiscounting transactions.95 Intangible property isdefined to include patents, patent applications,trade names, trademarks, service marks, copy-rights, and similar intangible assets.96

B. Exceptions

1. No Principal Purpose to Avoid Tax,Arm’s Length, and Payment to anUnrelated MemberThe Maryland addback provision does not apply

to any portion of interest or intangible expense tothe extent that, as determined by the comptroller:

(A) the transaction giving rise to the paymentof the interest expense or intangible expensedid not have as a principal purpose the avoid-ance of any portion of the Maryland corporateincome tax due;

(B) the interest or intangible expense was paidunder arm’s-length contracts at an arm’s-length rate of interest or price; and

(C) during the same tax year, the related mem-ber directly or indirectly paid, accrued, or in-curred the interest expense or intangible ex-pense to a person who is not a relatedmember.97

87Ky. Rev. Stat. Ann. section 141.205(3)(b).88Ky. Rev. Stat. Ann. section 141.205(3)(c).89Ky. Rev. Stat. Ann. section 141.205(3)(d).90Ky. Rev. Stat. Ann. section 141.205(5)(a).91Ky. Rev. Stat. Ann. section 141.205(5)(b).

92Ky. Rev. Stat. Ann. section 141.205(5)(c).93Md. Tax Gen. section 10-306.1(b)(2).94Md. Tax Gen. section 10-306.1(a)(5).95Md. Tax Gen. section 10-306.1(a)(5)(ii).96Md. Tax Gen. section 10-306.1(a)(6).97Md. Tax Gen. section 10-306.1(c).

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2. No Principal Purpose to Avoid Tax,Arm’s-Length, and Payment to RelatedMember Subject to Tax in Maryland orElsewhereThe Maryland addback provision does not apply


(A) the transaction giving rise to the paymentof the interest expense or intangible expensedid not have as a principal purpose the avoid-ance of any portion of the Maryland corporateincome tax due;(B) the interest or intangible expense was paidunder arm’s-length contracts at an arm’s-length rate of interest or price; and(C) the related member was subject to a taxmeasured by its net income or receipts inMaryland, another state, or a foreign nationthat has entered into a comprehensive taxtreaty with the United States, and the measureof the tax imposed included the interest orintangible expense received by the relatedmember and the aggregate effective tax rateimposed on the amounts received by the re-lated member is equal to or greater than 4percent, or the aggregate effective tax rateimposed on the amounts received by the recipi-ent is greater than or equal to the aggregateeffective tax rate that would have been im-posed on the additional income of the payercorporation if the interest expense or intan-gible expense had not been deducted.98

3. Payer and Recipient Included inCombined or Consolidated ReportThe Maryland addback provision does not apply


(A) the transaction giving rise to the paymentof the interest expense or intangible expensedid not have as a principal purpose the avoid-ance of any portion of the Maryland corporateincome tax due;(B) the interest or intangible expense was paidunder arm’s-length contracts at an arm’s-length rate of interest or price; and(C) the payer and recipient are both included ina combined or consolidated report and theeffective rate of tax determined using thelesser of the recipient’s apportionment factor orthe apportionment factor for the combined orconsolidated group is equal to or greater than 4

percent. In such a situation, the measure of taximposed by the jurisdiction is deemed to in-clude the interest or intangible expense paid tothe related party.99

4. No Principal Purpose to Avoid Tax,Arm’s-Length, and Payment to RelatedMember That Is a Bank (Limited to InterestExpenses)

The Maryland addback provision does not applyto any portion of interest expense to the extent that,as determined by the comptroller:

(A) the transaction giving rise to the paymentof the interest expense did not have as aprincipal purpose the avoidance of any portionof the Maryland corporate income tax due;

(B) the interest expense was paid under arm’s-length contracts at an arm’s-length rate ofinterest; and

(C) the corporation and the related member arebanks.100

5. Comptroller’s Ability to AdoptRegulations Regarding the 4 PercentEffective Tax Rate

The addback provision also permits the comptrol-ler to adopt regulations that would provide an alter-native to the 4 percent effective rate requirement fortransactions with related parties that are subject tostate gross receipts or net worth taxes or where thetaxpayer demonstrates to the satisfaction of thecomptroller that the avoidance of Maryland corpo-rate tax is not a principal purpose of the transactionand the comptroller determines that it is ‘‘impracti-cal’’ for the related member to satisfy the 4 percenteffective tax rate requirement.101

6. Agreement With ComptrollerMaryland’s addback provisions do not limit or

negate any other authority provided to the comptrol-ler under this article, including: (i) the authority tomake adjustments under Md. Tax Gen. section 10-109 (authorizing IRC-section-482-type adjustments)or section 10-402(d) (special apportionment); or (ii)the authority to enter into agreements and compro-mises otherwise allowed by law.102

C. Subtraction FromRelated Member’s Income

The addback provision also permits the corpora-tions to subtract interest and intangible expensesreceived from a related member to the extent that

98Md. Tax Gen. section 10-306.1(c), (d)(1). Note the excep-tion regarding foreign nations that have comprehensive taxtreaties with the United States is applicable for tax yearsbeginning on or after January 1, 2005.

99Md. Tax Gen. section 10-306.1(c), (e).100Md. Tax Gen. section 10-306.1(c).101Md. Tax Gen. section 10-306.1(c), (d)(2).102Md. Tax Gen. section 10-306(g)(2).

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the related member is subject to an addback ofinterest or intangible expenses in Maryland or an-other state.103

Massachusetts — Related-Member IntangibleExpenses and Costs

A. General Rule

For purposes of computing its net income inMassachusetts, a taxpayer is required to add backotherwise deductible interest expenses and costsand intangible expenses and costs directly or indi-rectly paid, accrued or incurred to, or in connectionwith one or more direct or indirect transactions withone or more related members.104

B. Exceptions

Corporations must complete Schedule ABIE toclaim exceptions to the addback of intangibles ex-penses.

When a taxpayer claims an exception to an add-back provision on its tax return without filing therequired schedule, the commissioner will notify thetaxpayer that it has filed an incorrect or insufficientreturn.105 When a taxpayer claims an exception toan addback provision using the schedule, the com-missioner may request additional information orevidence if he determines that an additional submis-sion would be necessary or helpful to evaluate thetaxpayer’s asserted addback exception claim. If thetaxpayer fails to respond to a request to provide thatinformation or evidence, the commissioner will no-tify the taxpayer that it has filed an incorrect orinsufficient return.

In cases in which the commissioner does notaccept a taxpayer’s addback exception claim, eitheras filed or subsequent to the submission of addi-tional requested information or evidence, the com-missioner will assess additional tax.106 In thosecases, the commissioner will send a Notice of Inten-tion to Assess to the taxpayer and afford the tax-payer an opportunity for a hearing, as providedunder Massachusetts General Laws chapter 62C,section 26(b).

1. Unreasonable

The related-member intangible expenses addbackdoes not apply if the taxpayer establishes by clearand convincing evidence, as determined by the com-missioner, that the adjustments are unreason-able.107

Taxpayers seeking to claim that an addback isunreasonable must do so on Schedule ABIE.108 PartI of Schedule ABIE permits a taxpayer to claim thatan addback would be unreasonable because it wouldresult in actual double taxation. Three specific ex-ceptions relating to double taxation may be claimedin Part 1.109

The first Part 1 exception applies when the tax-payer incurs a cost or expense to a related memberthat is taxed on the corresponding income by a U.S.state or foreign jurisdiction at an effective rate of taxthat is within three percentage points of the statu-tory Massachusetts rate.110 That exception does notapply to transactions with a related member whenthat related member files in another jurisdictionwith the taxpayer on a combined or unitary basis.

The second and third Part 1 exceptions are partialexceptions that apply to the specific portion of ataxpayer’s intangible cost or expense that is taxed toone or more related entities or individuals on aMassachusetts tax return.111 In those cases, theexception will apply to that portion of the cost orexpense that is actually subject to double tax.

The commissioner recognizes that there may beinstances of double taxation that cannot be evi-denced on Part 1. For example, there may be cases inwhich a taxpayer seeks a full exception concerning arelated member that is an individual or a partialexception concerning a related entity or individualthat does not file a Massachusetts return.112 In thosecases, the taxpayer may seek to claim the existenceof actual double taxation through Part 2 of ScheduleABIE.113

Technical Information Release 03-19 providesthat a taxpayer must submit sufficient informationto support a conclusion that the addback was unrea-sonable and that the taxpayer must establish thatthe transaction at issue was entered into for a validbusiness purpose, supported by economic substanceand at an arm’s-length consideration, to be eligiblefor the unreasonable exception.

2. Written Agreement

The related-member intangible expenses addbackdoes not apply if the taxpayer and the commissioneragree in writing to the application or use of analternative method of apportionment under section42.114

103Md. Tax Gen. section 10-306.1(f).104Mass. Gen. Laws ch. 63, section 31I(b).105Technical Information Release 03-19.106Technical Information Release 03-19.107Mass. Gen. Laws ch. 63 section 31I(c)(i)(A).

108Technical Information Release 03-19.109Technical Information Release 03-19.110Technical Information Release 03-19.111Technical Information Release 03-19.112Technical Information Release 03-19.113Technical Information Release 03-19.114Mass. Gen. Laws ch. 63 section 31I(c)(i)(B).

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3. No Principal Purpose to Avoid Tax andPayment to Unrelated MemberThe related-member intangible expenses addback

does not apply to the portion of interest expensesand costs and intangible expenses and costs that thetaxpayer establishes by a preponderance of theevidence meets both of the following: (A) the relatedmember during the same taxable year directly orindirectly paid, accrued, or incurred such portion toa person that is not a related member, and (B) thetransaction giving rise to the interest expenses andcosts or the intangible expenses and costs betweenthe taxpayer and the related member did not haveas a principal purpose the avoidance of any portionof the tax that would otherwise be due.115

This exception is claimed on Part 2 of ScheduleABIE.116 In general, a taxpayer should state that theintangibles payments were made, first, between thetaxpayer and a related member and, second, be-tween the related member and an unrelated party. Ifthe two sets of payments are not identical in kind oramount or in any other respect, the taxpayer shouldexplain the basis for the discrepancy. Also, thetaxpayer should state whether the payments weremade in either case under one or more writtenagreements and if so should briefly describe eachagreement. Further, the taxpayer should state howthe taxpayer actually used the intangible propertyin question.

Technical Information Release 03-19 also pro-vides that the taxpayer must establish that thetransaction at issue was entered into for a validbusiness purpose, supported by economic substanceand at an arm’s-length consideration.

Massachusetts — Related-Member InterestExpense

A. General RuleFor purposes of computing Massachusetts net

income, a taxpayer is required to add back otherwisedeductible interest paid, accrued or incurred to arelated member during the tax year.117

B. ExceptionsCorporations must complete Schedule ABI to

claim exceptions to the addback of related-memberinterest.

When a taxpayer claims an exception to an add-back provision on its tax return without filing therequired schedule, the commissioner will notify thetaxpayer that it has filed an incorrect or insufficientreturn.118 When a taxpayer claims an exception toan addback provision using the schedule, the com-

missioner may request additional information orevidence if he determines that an additional submis-sion would be necessary or helpful to evaluate thetaxpayer’s asserted addback exception claim. If thetaxpayer fails to respond to a request to provide thatinformation or evidence, the commissioner will no-tify the taxpayer that it has filed an incorrect orinsufficient return.

In cases in which the commissioner does notaccept a taxpayer’s addback exception claim, eitheras filed or subsequent to the submission of addi-tional requested information or evidence, the com-missioner will assess additional tax.119 In suchcases, the commissioner will send a Notice of Inten-tion to Assess to the taxpayer and afford the tax-payer an opportunity for a hearing, as providedunder Massachusetts General Laws chapter 62C,section 26(b).

1. Unreasonable

The related-member interest addback does notapply if the taxpayer establishes by clear and con-vincing evidence, as determined by the commis-sioner, that the disallowance of the deduction isunreasonable.120

A taxpayer seeking to claim that an addback isunreasonable must do so on Schedule ABI.121 Part Iof Schedule ABI permits a taxpayer to claim that anaddback would be unreasonable because it wouldresult in actual double taxation. Three specific ex-ceptions relating to double taxation may be claimedin Part 1.122

The first Part 1 exception applies when the tax-payer incurs a cost or expense to a related memberthat is taxed on the corresponding income by a U.S.state or foreign jurisdiction at an effective rate of taxthat is within 3 percentage points of the statutoryMassachusetts rate.123 This exception does not ap-ply to transactions with a related member when thatrelated member files in another jurisdiction with thetaxpayer on a combined or unitary basis.

The second and third Part 1 exceptions are partialexceptions that apply to the specific portion of ataxpayer’s interest cost or expense that is taxed toone or more related entities or individuals on aMassachusetts tax return.124 In such cases, theexception will apply to that portion of the cost orexpense that is actually subject to double tax.

115Mass. Gen. Laws ch. 63 section 31I(c)(ii).116Technical Information Release 03-19.117Mass. Gen. Laws ch. 63 section 31J(a).118Technical Information Release 03-19.

119Technical Information Release 03-19.120Mass. Gen. Laws ch. 63 section 31J(a).121Technical Information Release 03-19.122Technical Information Release 03-19.123Technical Information Release 03-19.124Technical Information Release 03-19.

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The commissioner recognizes that there may beinstances of double taxation that cannot be evi-denced on Part 1.125 For example, there may becases in which a taxpayer seeks a full exceptionregarding a related member that is an individual ora partial exception regarding a related entity orindividual that does not file a Massachusetts return.In those cases, the taxpayer may seek to claim theexistence of actual double taxation through Part 2 ofSchedule ABI.126 Refer to Technical InformationRelease 03-19 for the commissioner’s guidelines forqualifying for an exception in Part 2 of ScheduleABI.

2. Written AgreementThe related-member interest addback does not

apply if the taxpayer and the commissioner agree inwriting to the application of an alternative methodof apportionment under section 42.127

3. No Principal Purpose to Avoid Tax,Arm’s-Length Interest, and Related MemberSubject to Tax at a Threshold RateThe related-member interest addback does not

apply if the taxpayer establishes by clear and con-vincing evidence, as determined by the commis-sioner, that:

(i) a principal purpose of the transaction givingrise to the payment of interest was not to avoidpayment of taxes due;(ii) the interest is paid pursuant to a contractthat reflects an arm’s-length rate of interestand terms; and(iii) (A) the related member was subject to taxon its net income in Massachusetts or anotherstate or possession of the United States or aforeign nation;

(B) a measure of said tax included theinterest received from the taxpayer; and(C) the rate of tax applied to the interestreceived by the related member is no lessthan the statutory rate of tax applied tothe taxpayer by Massachusetts minus 3percentage points.128

Mississippi

A. General RuleMississippi requires a taxpayer to add back oth-

erwise deductible intangible and related interestexpenses and costs directly or indirectly paid, ac-crued to or incurred, in connection with transactionsdirectly or indirectly with one or more related mem-

bers.129 Intangible expenses and costs include ex-penses, losses, and costs related to or in connectionwith the acquisition, use, maintenance or manage-ment, ownership, sale, exchange, or any other dis-position of intangible property.130 Intangible ex-penses also include expenses or losses related to orincurred in connection with factoring transactionsor discounting transactions.131

B. Exceptions

1. Payment by Related MemberTo Unrelated Third Party

The Mississippi addback provision does not applyto the portion of intangible and related interestexpenses and costs paid to a related member thatthe related member directly or indirectly paid, ac-crued or incurred to a person during the sameincome year who is not a related member.132

2. No Principal Purpose to Avoid TaxAnd Related MemberNot an Intangible Holding Company

The Mississippi addback provision does not applyto the portion of intangible and related interestexpenses and costs that was paid to a related mem-ber primarily for a valid business purpose otherthan the avoidance of taxes when the related mem-ber is not primarily engaged in the acquisition, use,maintenance or management, ownership, sale, ex-change, or any other disposition of intangible prop-erty.133

New Jersey — Related-Member InterestExpense

A. General Rule

For privilege periods beginning on or after Janu-ary 1, 2002, interest paid, accrued, or incurred forthe privilege period to a related member must beadded back unless one of five exceptions applies.134

The related-member interest expense addback is aseparate provision from the related-member interestaddback for interest expenses that are related tointangible property.135

125Technical Information Release 03-19.126Technical Information Release 03-19.127Mass. Gen. Laws ch. 63 section 31J(a).128Mass. Gen. Laws ch. 63 section 31J(b).

129Miss. Code Ann. section 27-7-17(b).130Miss. Code Ann. section 27-7-17(2)(a)(i)(2).131Miss. Code Ann. section 27-7-17(2)(a)(i)(1).132Miss. Code Ann. section 27-7-17(2)(c)(i).133Miss. Code Ann. section 27-7-17(2)(c)(ii).134N.J. Stat. Ann. section 54:10A-4(k)(2)(I); N.J. Admin.

Code section 18:7-5.2(a)xviii; N.J. Admin. Code section18:7.5.18.

135N.J. Stat. Ann. section 54:10A-4.4 requires the addbackof interest expenses and costs related to the acquisition,maintenance, management, ownership, sale, exchange, ordisposition of intangible property.

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B. Exceptions

1. No Principal Purpose to Avoid Tax,Arm’s-Length Interest, and Income Subjectto Tax at Threshold RateThe related-member interest expense addback

does not apply to the extent that the taxpayerestablishes by clear and convincing evidence, asdetermined by the director, that:

(i) a principal purpose of the transaction givingrise to the payment of the interest was not toavoid corporation business tax (CBT),

(ii) the interest is paid pursuant to arm’s-length contracts at an arm’s-length rate ofinterest, and

(iii) (aa) the related member was subject to atax on its net income or receipts in New Jerseyor another state or possession of the UnitedStates or in a foreign nation,

(bb) a measure of the tax includes theinterest received from the related mem-ber, and

(cc) the rate of tax applied to the interestreceived by the related member is equalto or greater than a rate 3 percentagepoints less than the rate of tax applied totaxable interest by New Jersey.136

In comments to the regulations, the Division ofTaxation indicated that in order for the exception toapply, the related member must actually pay tax,not merely be subject to tax.137 That statement isinconsistent with the language of the regulationsthemselves, which require that the related memberbe subject to a tax ‘‘regardless of whether a tax wasactually paid on the related member.’’138 The regu-lations also provide that the interest expense mustbe taxed in a nonunitary state for the exception toapply.139

The division’s Web site explains that in testingwhether another jurisdiction has a tax rate no morethan 3 percentage points less than New Jersey’s taxrate, the division will look at the ‘‘effective’’ NewJersey tax rate after taking into account the appli-cable allocation factor. For example, if the tax rate inNew Jersey is 9 percent and the allocation factor is50 percent, then the effective tax rate applicable toany interest is 4.5 percent, in which case, to qualify

for the first exception, the effective rate in thejurisdiction in which the interest is taxed must be atleast 1.5 percent.140

The division has also said the first exception willapply in a case in which the taxpayer’s New Jerseyallocation factor is less than the related member’sNew Jersey allocation factor.141

In its regulations, the division indicated that thefirst exception for related-member interest expensewill apply if the related member is an individual andsole shareholder of the payer, the individual paysNew Jersey gross income tax on the interest re-ceived at a rate within 3 percentage points of 9percent, and the payer is properly capitalized.142

However, the division will disallow the deduction ofotherwise qualifying related-member interest paidto a stockholder by its wholly owned corporation ifthe corporation is undercapitalized.143

Corporations claiming exceptions to the interestaddback must complete and attach Schedule G-2 tothe CBT-100. It is the division’s position that prefil-ing approval is not necessary because the exceptionsare built into Schedule G-2.144 To qualify for the firstexception (which is Exception 2 of Part I of ScheduleG-2), the corporation must also submit a copy of thereturn from the state, possession, or foreign nationon which the related member reported interest in-come.

2. UnreasonableThe related-member interest expense addback

does not apply if the taxpayer establishes by clearand convincing evidence, as determined by the di-rector, that the disallowance of the interest deduc-tion is unreasonable.145

The division’s regulations indicate that the sec-ond exception for unreasonableness applies if thetaxpayer establishes that the disallowance of a de-duction is unreasonable by showing the extent towhich the related party pays tax in New Jersey onthe income stream.146 In comments to the regula-tions, the division advised that the director wouldexercise his discretion through the taxpayer’s propercompletion of Exception 3, in Part I, Schedule G-2 ofForm CBT-100.147 Exception 3 pertains to the situ-ation in which the recipient files a New Jersey CBTreturn and includes the interest in its entire net

136N.J. Stat. Ann. section 54:10A-4(k)(2)(I); N.J. Admin.Code section 18:7-5.18.

13735 N.J.R. 1573, 1574 (Apr. 7, 2003) (stating that ‘‘thetaxpayer must actually pay tax for the exception to apply, notmerely be subject to tax’’).

138N.J. Admin. Code section 18:7-5.18(a)1.iii.139N.J. Admin. Code section 18:7-5.18(a)5, Example 5.

140Questions and Answers Regarding the Business TaxReform Act of 2002 (Q&A), 6, http://www.state.nj.us/treasury/taxation/cbtfaq.htm.

141Q&A 7.142N.J. Admin. Code section 18:7-5.18(a)5, Example 6.143N.J. Admin. Code section 18:7-5.18(a)5, Example 7.144Q&A 8.145N.J. Stat. Ann. section 54:10A-4(k)(2)(I); N.J. Admin.

Code section 18:7-5.18(a)2.146N.J. Admin. Code section 18:7-5.18(a)2.14735 N.J.R. 1573, 1574 (Apr. 7, 2003).

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income. It appears, therefore, that the only basis forunreasonableness that is recognized on ScheduleG-2 arises when the income is subject to doubletaxation in New Jersey.

In the context of discussing the exception forinterest indirectly paid to an independent lender(discussed below), the Assembly Budget CommitteeStatement to A2501 gave the following example ofanother situation that would qualify for the unrea-sonableness exception to the related-party interestaddback rules:

[T]he bill permits a taxpayer to keep the de-duction if the interest paid is ultimately paid toa third-party unrelated lender, as evidenced bya guarantee provided by the taxpayer to theoutside lender. If a taxpayer can demonstratethat, despite the absence of a guarantee, inter-est is being paid on a loan that was simply‘‘pushed down’’ from a third party lender, thenit would be unreasonable to disallow the inter-est deduction. As the deduction is retained byexception to a general rule that disallows thededuction, the effect is to require the taxpayerto secure prior approval from the director(through general regulation or case-by-case de-termination) before departing from the generalrule of nondeductibility.148

According to the instructions to Schedule G-2, ifthe corporation believes the addback is unreason-able for a reason that is not described on ScheduleG-2, the corporation must initially add back theexpense and then submit a separate Refund Claim(Form A-3730) stipulating all the facts and provid-ing all applicable evidence to support the taxpayer’sclaim. However, the division’s Web site also indi-cates that if the taxpayer believes the addback isunreasonable, then the taxpayer could file a returnand request relief under N.J.S.A. 54:10A-8.149


The related-member interest expense addbackdoes not apply if the taxpayer and the director agreein writing to the application or use of an alternativemethod of apportionment under N.J.S.A. 54:10A-8.150 It is the division’s position that the alternativeapportionment exception will be allowed if the tax-payer is taxed on more than 100 percent of itsincome.151 The procedure for obtaining an alterna-tive apportionment method is not described.

4. Foreign Related MemberWith Income Tax TreatyThe related-member interest expense addback

does not apply to the extent that the taxpayerestablishes by a preponderance of the evidence, asdetermined by the director, that the interest isdirectly or indirectly paid, accrued or incurred to arelated member in a foreign nation, which has inforce a comprehensive152 income tax treaty with theUnited States.153

Examples in the division’s regulations indicatethat the exception to the related-member interestexpense addback applies only if the loans are atarm’s-length rates.154 However, neither the statutenor the regulatory provision describing the excep-tion requires arm’s-length interest rates.155

The statute and regulations provide that in orderto qualify for the foreign-related-member exception,the taxpayer must disclose on its return for theprivilege period (1) the name of the related member;(2) the amount paid to the related member; (3) thenature of the payment or, alternatively, a copy ofForm 5472 or its equivalent as an attachment toForm CBT-100; and (4) the relevant foreign na-tion.156 However, Exception 1 of Part I of ScheduleG-2 only requires (1) the name of the related mem-ber, (2) the name of the foreign nation, (3) a descrip-tion of the treaty, and (4) the amount deducted.

5. Independent LenderWith Guaranteed DebtThe related-member interest expense addback

does not apply to the extent that the taxpayerestablishes that the interest is directly or indirectlypaid, accrued or incurred to an independent lenderthrough a related member as conduit, provided thatthe taxpayer legally guarantees the debt on whichthe interest is required.157 The legislative historyindicates that this exception was intended to coverthe situation where debt is ‘‘pushed down’’ from a

148Assembly Budget Committee Statement to A2501 (June27, 2002) at 2-3.

149Q&A 8.150N.J. Stat. Ann. section 54:10A-4(k)(2)(I); N.J. Admin.

Code section 18:7-5.18(a)2.151Q&A 12.

152The division is still reviewing what is meant by theterm ‘‘comprehensive’’ in the context of a treaty between theUnited States and a foreign country. Currently, it includesincome tax treaties between the United States and thefollowing countries: Canada, United Kingdom, Denmark,France, Ireland, Luxembourg, Mexico, Netherlands, SouthAfrica, Switzerland, and Venezuela. In addition, a compre-hensive treaty refers to all forms of income. Q&A 11.

153N.J. Stat. Ann. section 54:10A-4(k)(2)(I); N.J. Admin.Code section 18:7-5.2(a)1.xviii; N.J. Admin. Code section18:7-5.18(a)3.i.

154N.J. Admin. Code section 18:7-5.18(a)5.155N.J. Stat. Ann. section 54:10A-4(k)(2)(I); N.J. Admin.

Code section 18:7-5.18(a)3.i.156N.J. Stat. Ann. section 54:10A-4(k)(2)(I); N.J. Admin.

Code section 18:7-5.18(a)4.vii.157N.J. Stat. Ann. section 54:10A-4(k)(2)(I); N.J. Admin.

Code 18:7-5.2(a)1.xviii; N.J. Admin. Code section 18:7-5.18(a).3.ii.

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corporate parent to a subsidiary but involves aregular, market-rate loan from an outside lender.158

In comments to 2003 regulations, the divisionexplained that in the context of a parent corporation‘‘pushing down’’ debt to a subsidiary, since guaran-teeing a debt to a third party may be difficult inpractice, the result can be achieved when the bor-rower structures a new loan to the subsidiary ratherthan guaranteeing the debt.159 However, in such acircumstance, the division warned that the loan andrelated documents are subject to examination on thebasis of arm’s-length principles.160 In addition, in a‘‘cash sweep situation’’ in which funds of commonentities are swept into a single account and thenloaned out on an as-needed basis, it is the division’sposition that interest must be credited to the entityrelinquishing the funds and each party must make aprofit on the transaction.161 The regulatory com-ments further advise that a pledge of stock does notmeet the guarantee requirement when a publicholding company pledges the subsidiary’s assets orstock in the subsidiary as security.162

To qualify for the independent lender exceptiondescribed in Exception 4 of Part I of Schedule G-2,the taxpayer must provide (1) the name of theindependent lender, (2) the amount of the indebted-ness, and (3) the amount deducted. A copy of the loanagreement evidencing the guarantee of the debt bythe taxpayer must also be submitted with the re-turn.

C. Part I of Schedule G-2The exceptions described on Schedule G-2 vary

somewhat from the exceptions set forth in the stat-ute and regulations. Part I of Schedule G-2 containsfour exceptions: (1) amounts paid, accrued, or in-curred to a related member(s) in a foreign nation; (2)interest paid that was subject to tax; (3) interestpaid, accrued, or incurred to related corporationsfiling in New Jersey; and (4) interest paid, accrued,or incurred to an independent lender.

New Jersey — Related-Member IntangibleExpenses and Costs

A. General RuleRegarding privilege periods beginning on or after

January 1, 2002, a taxpayer must add back other-wise deductible interest expenses and costs andintangible expenses and costs directly or indirectly

paid, accrued or incurred to, or in connection withone or more direct or indirect transactions with oneor more related members unless one of four excep-tions applies.163 The related-member interest add-back for interest expenses that are related to intan-gible property is a separate provision from therelated-member interest expenses addback, which isdiscussed above.164

B. Exceptions

While the related-member intangible expensesaddback provision was added at the same time asthe related-member interest addback provision, theavailable exceptions for each provision are not iden-tical.

1. Foreign Related MemberWith Income Tax Treaty

The related-member intangible expenses addbackdoes not apply if the interest expenses and costs andintangible expenses and costs are directly or indi-rectly paid, accrued or incurred to a related memberin a foreign nation that has in force a comprehen-sive165 income tax treaty with the United States.166

The regulations provide that in order to qualifyfor the foreign-related-member exception, the tax-payer must disclose on its return for the privilegeperiod (1) the name of the related member, (2) thecountry of domicile of the related member, (3) theamount paid to the related member, and (4) thenature of the payment or, alternatively, a copy ofForm 5472 or its equivalent as an attachment toform CBT-100.167 However, Exception 1 of Part II ofSchedule G-2 only requires (1) the name of therelated member, (2) the name of the foreign nation,(3) a description of the treaty, and (4) the amountdeducted.

2. Unreasonable

The second exception is available if the taxpayerestablishes by clear and convincing evidence, asdetermined by the director, that the adjustments are

158Assembly Budget Committee Statement to A 2501(June 27, 2002) at 3.

15935 N.J.R. 1573, 1574 (Apr. 7, 2003).160Id.161Id. See also, Q&A 9.162Id. However, the division has also stated that if all

entities are listed on the note and there is a flow of funds, thatwould satisfy the exception. See Q&A 9.

163N.J. Stat. Ann. section 54:10A-4.4.b; N.J. Admin. Codesection 18:7-5.2(a)1.xix.

164N.J. Stat. Ann. section 54:10A-4(k)(I) requires the add-back of interest paid, accrued, or incurred to a relatedmember, unless a specific exception applies.

165The division is still reviewing what is meant by theterm ‘‘comprehensive’’ in the context of a treaty between theUnited States and a foreign country. Currently, it includesincome tax treaties between the United States and thefollowing countries: Canada, United Kingdom, Denmark,France, Ireland, Luxembourg, Mexico, Netherlands, SouthAfrica, Switzerland, and Venezuela. In addition, a compre-hensive treaty refers to all forms of income. Q&A 11.

166N.J. Stat. Ann. section 54:10A-4.4.c(1)(a); N.J. Admin.Code section 18:7-5.18(b)1.

167N.J. Admin. Code section 18:7-5.18(b)5.x.

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unreasonable.168 The division’s regulations indicatethat the exception for unreasonableness applies ifthe taxpayer establishes that the disallowance of adeduction is unreasonable by showing the extent towhich the payee pays tax in New Jersey on theincome stream.169 Consistent with that position,Exception 2 of Part II of Schedule G provides onexception if the related member files a CBT returnand includes the intangible related amounts in in-come.

Exception 2 appears to be the only basis forunreasonableness that is recognized on ScheduleG-2.

If the corporation believes the addback is unrea-sonable for a reason that is not described on Sched-ule G-2, the corporation must initially add back theexpense and then submit a separate refund claim(Form A-3730) stipulating all the facts and provid-ing all applicable evidence to support the taxpayer’sclaim. However, the division’s Web site also indi-cates that if the taxpayer believes the addback isunreasonable, then the taxpayer could file a returnand request relief under N.J. Stat. Ann. section54:10A-8.170


Related-member intangible expenses are not sub-ject to addback if the taxpayer and the director agreein writing to the application or use of an alternativemethod of apportionment under N.J. Stat. Ann.section 54:10A-8.171 The division has indicated thatthe alternative apportionment exception arises ifthe taxpayer is taxed on more than 100 percent of itsincome.172 The procedure for obtaining a writtenagreement as to an alternative apportionmentmethod is not described.

4. No Principal Purpose to Avoid Tax andUnrelated Member

Related-member intangible expenses are not sub-ject to addback if the taxpayer establishes by apreponderance of the evidence that the relatedmember, during the same income year, directly orindirectly paid, received, accrued, or incurred theportion to or from a person that is not a relatedmember, and the transaction giving rise to theinterest expenses and costs and intangible expensesand costs between the taxpayer and the related

member did not have as a principal purpose theavoidance of any portion of the CBT or gross incometax due.173

Part II of Schedule G-2 does not include the finalexception to the related-member intangible expenseaddback. Accordingly, taxpayers seeking to qualifyfor the exception must initially add back the expenseand then file a separate Refund Claim (FormA-3730) stipulating all the facts and providing allapplicable evidence to support the taxpayer’s claim.

New York

A. General Rule

For the purpose of computing New York stateentire net income or other applicable taxable bases,a taxpayer must add back royalty payments to arelated member during the taxable year to theextent deductible in calculating federal taxable in-come.174

B. Exceptions

1. Unrelated Member, Valid BusinessPurpose, and Arm’s-Length Payments

The New York royalty payment addback does notapply if and to the extent that the related memberduring the same tax year directly or indirectly paidor incurred the amount to a person or entity that isnot a related member, and that transaction wasdone for a valid business purpose and the paymentsare made at arm’s length.175

A ‘‘valid business purpose’’ is one or more businesspurposes, other than the avoidance or reduction oftaxation, which alone or in combination constitutethe primary motivation for some business activity ortransaction that changes in a meaningful way, apartfrom tax effects, the economic position of the tax-payer.176 A change in the economic position of thetaxpayer includes an increase in the market share ofthe taxpayer, or the entry by the taxpayer into newbusiness markets.177

2. Foreign Related Member With IncomeTax Treaty and Threshold Rate

The New York royalty payment addback does notapply if and to the extent that the royalty paymentsare paid or incurred to a related member organizedunder the laws of a country other than the UnitedStates, are subject to a comprehensive income taxtreaty between that country and the United States,

168N.J. Stat. Ann. section 54:10A-4.4c(1)(b); N.J. Admin.Code section 18:7-5.18(b)3.

169N.J. Admin. Code section 18:7-5.18(b)3.170Q&A 8.171N.J. Stat. Ann. section 54:10A-4.4(c)(1)(c); N.J. Admin.

Code section 18:7-5.18(b)4.172Q&A 12.

173N.J. Stat. Ann. section 54:10A-4.4(c)(3); N.J. Admin.Code section 18:7-5.18(b)2.

174N.Y. Tax Law section 208(9)(o)(2)(A).175N.Y. Tax Law section 208(9)(o)(2)(B)(i).176N.Y. Tax Law section 208(9)(o)(1)(D).177N.Y. Tax Law section 208(9)(o)(1)(D).

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and are taxed in that country at a tax rate at leastequal to that imposed by New York.178

New York City

A. General RuleFor the purpose of computing entire net income

subject to New York City tax or other applicabletaxable bases, a taxpayer must add back royaltypayments to a related member during the tax year tothe extent deductible in calculating federal taxableincome.179

B. Exceptions

1. Unrelated Member, Valid BusinessPurpose, and Arm’s-Length PaymentsThe New York City addback of royalty payments

will not be required if and to the extent that therelated member during the same taxable year di-rectly or indirectly paid or incurred the amount to aperson or entity that is not a related member, andthe transaction was done for a valid business pur-pose and the payments are made at arm’s length.180

A ‘‘valid business purpose’’ is one or more businesspurposes, other than the avoidance or reduction oftaxation, which alone or in combination constitutethe primary motivation for some business activity ortransaction, which activity or transaction changes ina meaningful way, apart from tax effects, the eco-nomic position of the taxpayer.181 A change in theeconomic position of the taxpayer includes an in-crease in the market share of the taxpayer, or theentry by the taxpayer into new business markets.

2. Foreign Related MemberWith Income Tax TreatyAnd Threshold RateThe New York City addback of royalty payments

will not be required if and to the extent that theroyalty payments are paid or incurred to a relatedmember organized under the laws of a country otherthan the United States, are subject to a comprehen-sive income tax treaty between that country and theUnited States, and are taxed in that country at a taxrate at least equal to that imposed by New York.182

North Carolina

A. General RuleNorth Carolina requires royalty payments paid to

a related member for the use of trademarks andsimilar intangibles in North Carolina to be addedback in determining net income to the extent those

payments are deducted in calculating federal tax-able income unless the recipient of the income issubject to tax in North Carolina.183 North Carolina’saddback provision does not address patents, know-how, and related intangibles.184

B. Exceptions

1. Related Member’s Income Subject to TaxNorth Carolina permits taxpayers to avoid the

addback of royalty payments to a related member ifthe related member elects to include the incomeresulting from the royalty payments on a NorthCarolina tax return for the same tax period.185 It isimportant to note that North Carolina considers theincome from royalty payments for the use of trade-marks in the state to constitute income derived fromdoing business in the state.186

2. Royalty Paid to Unrelated Third PartyBy a Related MemberNorth Carolina permits taxpayers to avoid the

addback of royalty payments made to a relatedmember if the related member directly or indirectlypaid, accrued, or incurred the amount to a personwho is not a related member.187

C. SubtractionFrom Related Member’s Income

North Carolina also permits the deduction ofroyalty payments received from a related memberwho added those payments to income for the sametax year.188

Ohio

A. General RuleFor purposes of computing net income in Ohio, a

corporation must add back interest expenses andcosts and intangible expenses and costs paid, ac-crued, or incurred to, or in connection directly orindirectly with one or more direct or indirect trans-actions with one or more of the following relatedmembers:189

(1) Any related member whose activities, inany one state, are primarily limited to themaintenance and management of intangibleinvestments or of the intangible investments ofcorporations, business trusts, or other entitiesregistered as investment companies under theInvestment Company Act of 1940, 15 U.S.C.

178N.Y. Tax Law section 208(9)(o)(2)(B)(ii).179N.Y.C. Admin. Code section 11-602(8)(n)(2)(A).180N.Y.C. Admin. Code section 11-602(8)(n)(2)(B)(i).181N.Y.C. Admin. Code section 11-602(8)(n)(1)(D).182N.Y.C. Admin. Code section 11-602(8)(n)(2)(B)(ii).

183N.C. Gen. Stat. section 105-130.5(a)(14); N.C. Gen. Stat.section 105-130.7A(a).

184See N.C. Gen. Stat. section 405-130.7A(b)(2), (b)(6),(b)(7), and (b)(8).

185N.C. Gen. Stat. section 405-130.7A(c)(1).186N.C. Gen. Stat. section 405-130.7A(a).187N.C. Gen. Stat. section 405-130.7A(c)(2).188N.C. Gen. Stat. section 105-130.5(b)(20).189Ohio R.C. section 5733.042(C)(1)-(7).

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80a-1 et seq., as amended, and the collectionand distribution of the income from those in-vestments or from tangible property physicallylocated outside that state.

(2) Any related member that is a personalholding company as defined in section 542 ofthe IRC without regard to the stock ownershiprequirements set forth in section 542(a)(2) ofthe IRC.

(3) Any related member that is not a corpora-tion and is directly, indirectly, constructively, orbeneficially owned in whole or in part by apersonal holding company as defined in section542 of the IRC without regard to the stockownership requirements set forth in section542(a)(2) of the IRC.

(4) Any related member that is a foreign per-sonal holding company as defined in section552 of the IRC.

(5) Any related member that is not a corpora-tion and is directly, indirectly, constructively, orbeneficially owned in whole or in part by aforeign personal holding company as defined insection 552 of the IRC.

(6) Any related member if that related memberor another related member directly or indi-rectly paid, accrued, or incurred to, or in con-nection with one or more direct or indirecttransactions with, another related member anyinterest expenses and costs or intangible ex-penses and costs in an amount less than, equalto, or greater than such amounts received fromthe corporation. This section applies only if,within a 120-month period commencing threeyears before the beginning of the tax year, arelated member directly or indirectly paid, ac-crued, or incurred those amounts or lossesregarding one or more direct or indirect trans-actions with an entity described in paragraphs(1) through (5). A rebuttable presumption ex-ists that a related member did so pay, accrue,or incur such amounts or losses regarding oneor more direct or indirect transactions with anentity described in paragraphs (1) through (5).A corporation can rebut this presumption onlywith a preponderance of the evidence to thecontrary.

(7) Any related member that, regarding indebt-edness directly or indirectly owed by the corpo-ration to the related member, directly or indi-rectly charged or imposed on the corporationan excess interest rate.

B. Exceptions

1. UnreasonableThe Ohio addback does not apply if the corpora-

tion establishes by clear and convincing evidencethat the adjustments are unreasonable.190

2. Written AgreementThe Ohio addback does not apply if the corpora-

tion and the tax commissioner agree in writing tothe application or use of alternative adjustmentsand computations to more properly reflect the baserequired to be determined in accordance with OhioRevised Code section 5733.05(B).191

3. No Principal Purpose to Avoid Tax andUnrelated MemberConcerning related-member transactions de-

scribed in paragraphs (1) to (5), the Ohio addbackdoes not apply to such portion of interest expensesand costs and intangible expenses and costs that thecorporation can establish by a preponderance of theevidence meets both of the following:

(A) The related member during the same taxyear directly or indirectly paid, accrued, orincurred such portion to a person who is not arelated member, and(B) The transaction giving rise to the interestexpenses and costs or the intangible expensesand costs between the corporation and therelated member did not have as a principalpurpose the avoidance of any portion of the taxdue under this chapter.192

4. No Principal Purpose to Avoid Tax andPayment to Unrelated Member(One Step Removed)Regarding related-member transactions de-

scribed in paragraph (6), the Ohio addback does notapply to the portion of interest expenses and costsand intangible expenses and costs that the corpora-tion can establish by a preponderance of the evi-dence meets both of the following:

(A) The entity described in any of paragraphs(1) to (6) to whom the related member directlyor indirectly paid, accrued, or incurred suchportion, in turn during the same tax yeardirectly or indirectly paid, accrued, or incurredsuch portion to a person who is not a relatedmember, and

190Ohio R.C. section 5733.042(D)(1)(a).191Ohio R.C. section 5733.042(D)(1)(b).192Ohio R.C. section 5733.042(D)(2).

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(B) The transaction or transactions giving riseto the interest expenses and costs or the intan-gible expenses and costs between the corpora-tion, the related member, and the entity de-scribed in any of paragraphs (1) to (5) did nothave as a principal purpose the avoidance ofany portion of the tax due.193

5. Combined Return ExceptionThe Ohio addback applies except to the extent

that the increased tax, if any, attributable to suchadjustments would have been avoided if both thecorporation and the related member had been eli-gible to make and had timely made the election tocombine in accordance with Ohio R.C. section5733.052(B).194

6. No Principal Purpose to Avoid Tax andIncome Subject to Tax in Another StateA taxpayer may deduct an amount equal to the

sum of each related member’s ‘‘net interest income’’and ‘‘net intangible income’’ actually allocated andapportioned to other states that impose a tax on ormeasured by income.195 The deduction is limited tothe increase in Ohio taxable income resulting fromthe addback.

Net interest income is the excess of interestreceived by a related member from the taxpayerover interest expenses and costs paid or accrued bythe related member to another related member. Netintangible income is the excess of income received bya related member from the taxpayer for the taxpay-er’s use of intangible property over intangible ex-penses paid or accrued by the related member toanother related member.

‘‘Other states’’ does not include those states underwhose laws the taxpayer files or could have electedto file with the related member (or the relatedmember files or could have elected to file withanother related member) a combined income taxreport or return, a consolidated income tax report orreturn, or any other report or return where thatreport or return is due because of the imposition of atax measured on or by income and that report orreturn results in the elimination of the tax effectsfrom transactions directly or indirectly between ei-ther the taxpayer and the related member or therelated member and another corporation if thatother corporation, during a 120-month period com-mencing three years before the beginning of the taxyear, directly or indirectly paid, accrued, or incurredintangible expenses and costs or interest expensesand costs to an entity described in Ohio R.C. section5733.042(C)(1) to (5).

The deduction for income that is subject to tax isavailable only if the taxpayer establishes with clearand convincing evidence that the intangible ex-penses and costs and the interest expenses and costspaid, accrued, or incurred by the corporation to arelated member did not have as a principal purposethe avoidance of any portion of the tax imposed byOhio R.C. section 5733.06.196

Tennessee

A. General Rule

Tennessee requires the addition of any otherwisedeductible intangible expenses paid, accrued, orincurred in connection with a transaction with oneor more affiliated entities in determining the tax-payer’s Tennessee net earnings or losses.197 Intan-gible expenses include expenses related to, or inconnection with, the acquisition, use, maintenanceor management, ownership, sale, exchange, license,or any other disposition of intangible property.198

B. Exceptions

1. Disclosure of Related-Party Transaction

Tennessee permits a taxpayer to deduct from itsTennessee net earnings or losses any intangibleexpenses paid or incurred in a transaction withaffiliated entities if the transaction is disclosed onthe face of the Tennessee tax return and if theappropriate schedule is completed.199 Those trans-actions must be disclosed on the Department ofRevenue’s Intangible Expense Disclosure Form.200

Taxpayers that deduct intangible expenses arisingfrom a transaction with an affiliated entity in deter-mining Tennessee net earnings and fail to disclosethose transactions are subject to negligence penal-ties.201

C. SubtractionFrom Affiliated Entity’s Income

An affiliated entity receiving intangible income ispermitted to deduct any intangible income includedin the computation of that entity’s net earnings tothe extent that the corresponding intangible ex-pense is not disclosed or to the extent that thecorresponding intangible expense is otherwise disal-lowed.202

193Ohio R.C. section 5733.042(D)(3).194Ohio R.C. section 5733.042(D)(4).195Ohio R.C. section 5733.055(B). See Schedule B-3 of Ohio

Form FT 1120.

196Ohio R.C. section 5733.055(C).197Tenn. Code Ann. section 67-4-2006(b)(1)(L).198Tenn. Code Ann. section 67-4-2004(18).199Tenn. Code Ann. section 67-4-2006(b)(2)(O).200See Tennessee Department of Revenue Excise Tax No-

tice No. 04-32 and ‘‘Franchise and Excise Tax IntangibleExpense Disclosure Form.’’

201Tenn. Code Ann. section 67-4-2006(e).202Tenn. Code Ann. section 67-4-2006(b)(2)(P).

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Virginia

A. General Rule

Virginia’s intangible expense addback provisionrequires any intangible expenses and costs paid inconnection with transactions with related membersto be added back to a taxpayer’s federal taxableincome.203 Intangible expenses and costs includeexpenses, losses, and costs for, related to, or inconnection directly or indirectly with the acquisi-tion, use, maintenance or management, ownership,sale, exchange, lease, transfer, or any other disposi-tion of intangible property.204 Intangible expensesalso include losses related to or incurred in connec-tion directly or indirectly with factoring transactionsor discounting transactions.205 Intangible propertyincludes patents, patent applications, trade names,trademarks, service marks, copyrights, and similartypes of intangible assets.206

Virginia’s interest expense addback provides thatany interest expenses paid in connection with trans-actions with related members are required to beadded back to a taxpayer’s federal taxable income.207

Interest expenses and costs are limited to expensesand costs related to the ‘‘acquisition, use, mainte-nance, management, ownership, sale, exchange,lease, transfer, or disposition of intangible prop-erty.’’208 Interest paid to a related entity is presumedto be related to intangible property if the corporationhas incurred intangible expenses or costs to thesame or any other related entity in the same year.209

B. Exceptions — Intangible Expense Addback

1. Related Member’s Income Subject to Tax

Virginia does not require the addback of intan-gible expenses paid to a related member if thecorresponding income received by the related mem-ber is subject to tax in Virginia, another state, or aforeign government that has a comprehensive taxtreaty with the United States.210 To substantiatethat the related member is subject to a tax inanother jurisdiction, the taxpayer is required toattach a copy of the related member’s tax returnfiled in the other jurisdiction.211 To be consideredsubject to tax, the inclusion of the correspondingincome on the related member’s return must resultin a nontrivial increase in tax liability or a reductionof an operating loss after consideration of all of the

deductions, credits, exemptions, and other tax poli-cies and preferences affecting the liability of therelated member.212

2. Related-Party Licenses to Third Partiesand Terms of Related-Party TransactionsAre Similar to Third-Party LicensesVirginia does not require the addback of intan-

gible expenses paid to a related member if therelated party receives at least one-third of its rev-enues from the licensing of intangible property tothird parties and the license between the corpora-tion and the related party is made at rates andterms similar to the agreements with third par-ties.213

3. Related Party Pays Expenses toUnrelated Third Party and PrincipalPurpose Was Not AvoidanceOf Virginia TaxesVirginia does not require the addback of intan-

gible expenses paid to a related member if therelated member paid the expenses to a person who isnot a related member and the transaction giving riseto the intangible expenses and costs between thecorporation and the related member did not have asits principal purpose the avoidance of Virginiataxes.214 When a transaction results in significanttax savings it is presumed that the savings were aprincipal purpose for the transaction, even thoughthe transaction may also serve other purposes.215

The taxpayer must show that the other purposes arespecific to the aspects of the transaction that gener-ated the tax savings, and that the other purposes areso important that the transaction would have oc-curred even if there were no tax savings.216 Theactivities of the corporation and the related entitywill be examined to determine if they are consistentwith the stated purposes for the transaction.217

4. Discretionary Adjustment BasedOn Valid Business PurposeA corporation that is subject to the intangible

expense addback provisions may petition the Vir-ginia tax commissioner to consider evidence relatedto the related-member transactions after the corpo-ration computes and pays its tax utilizing the add-back provisions. If the corporation can demonstrateto the commissioner’s ‘‘sole satisfaction, by clear andconvincing evidence’’ that the related-member trans-action had a valid business purpose other than the‘‘avoidance or reduction’’ in tax, the commissioner

203Va. Code Ann. section 58.1-402(B)(8)(a).204Va. Code Ann. section 58.1-302.205Va. Code Ann. section 58.1-302.206Va. Code Ann. section 58.1-302.207Va. Code Ann. section 58.1-402(B)(9)(a).208Va. Code Ann. section 58.1-302.209Instructions for Form 500-AB.210Va. Code Ann. section 58.1-402(B)(8)(a)(1).211See Form 500-AB.

212Instructions for Form 500-AB.213Va. Code Ann. section 58.1-402(B)(8)(a)(2).214Va. Code Ann. section 58.1-402(B)(8)(a)(3).215Instructions for Form 500-AB.216Instructions for Form 500-AB.217Instructions for Form 500-AB.

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shall permit the corporation to file an amendedreturn not applying the addback provisions.218 Thecommissioner may also permit those corporations tonot apply the addback provisions in filing tax re-turns for subsequent years.219 The commissionermay charge corporations a fee for all costs related tothe review of the corporation’s petition. Additionally,no action of the commissioner related to the addbackprovisions ‘‘shall be maintained in any court of thisCommonwealth.’’220

5. No Limit on Department’s AuthorityThe Virginia addback statute also provides that it

shall not be construed to limit or negate the Depart-ment of Taxation’s authority to equitably adjust acorporation’s tax to properly reflect the businessdone by the corporation within the state.221

C. Exceptions — Interest Expense Addback

1. General Requirements for ExemptionThe following requirements must be met to

qualify for the specific exceptions to the addbackprovisions listed below: 1) the related member hassubstantial operations relating to interest-generating activities in which the related memberpays expenses for at least five full-time employeeswho maintain, manage, defend, or are otherwiseresponsible for operation or administration relatedto the interest-generating activities; 2) the interestexpenses are not related to the acquisition, mainte-nance, management, sale, exchange, or dispositionof intangible property; and 3) the transaction be-tween the corporation and the related member has avalid business purpose other than the avoidance orreduction of tax and the payments between theparties are at arm’s-length rates and terms.222

a. Related Member Subject to Tax. No add-back is required if the above requirements are metand the income received by the related member issubject to tax in Virginia, another state, or in aforeign country with a comprehensive tax treatywith the United States.223

b. Preexisting Contract. No addback is re-quired if the above requirements are met and theinterest payments arise under a preexisting contractentered into when the parties were not relatedmembers.224

c. Related-Member Transactions With ThirdParties. No addback is required if the above re-quirements are met and the related member en-gages in transactions with unrelated parties thatgenerate more than $2 million of annual revenue.225

d. Related Member Subject to Tax. No add-back is required if the above requirements are metand the related-party transaction is at arm’s-lengthrates and terms and either: (i) the funds for theunderlying debt are borrowed from an unrelatedparty or the payment is passed through to an unre-lated party; (ii) the debt is part of an aggregatedfunds management or portfolio investment activityfor two or more related parties; (iii) the borrowedfunds are used in the expansion of business opera-tions; or (iv) the intercompany debt is a result ofdebt restructuring or the passthrough of acquisition-related debt.226

2. Discretionary Adjustment BasedOn Valid Business PurposeA corporation that is subject to the interest ex-

pense addback provisions may petition the Virginiatax commissioner to consider evidence related to therelated-member transactions after the corporationcomputes and pays its tax utilizing the addbackprovisions. If the corporation can demonstrate to thecommissioner’s ‘‘sole satisfaction, by clear and con-vincing evidence’’ that the related-member transac-tion had a valid business purpose other than the‘‘avoidance or reduction’’ in tax and that the pay-ments were at arm’s-length rates, the commissionershall permit the corporation to file an amendedreturn not applying the addback provisions.227 Thecommissioner may also permit those corporations tonot apply the addback provisions in filing tax re-turns for subsequent years. The commissioner maycharge corporations a fee for all costs related to thereview of the corporation’s petition.228 Additionally,no action of the commissioner related to the addbackprovisions ‘‘shall be maintained in any court of thisCommonwealth.’’229

3. No Limit on Department’s AuthorityThe Virginia interest addback statute also pro-

vides that it shall not be construed to limit or negatethe department’s authority to equitably adjust acorporation’s tax to properly reflect the businessdone by the corporation within the state.230 ✰

218Va. Code Ann. section 58.1-402(B)(8)(b).219Va. Code Ann. section 58.1-402(B)(8)(b).220Va. Code Ann. section 58.1-402(B)(8)(b).221Va. Code Ann. section 58.1-402(B)(8)(c).222Va. Code Ann. section 58.1-402(B)(9)(a)(1), (2), (3).223Va. Code Ann. section 58.1-402(B)(9)(a)(4)(i).224Va. Code Ann. section 58.1-402(B)(9)(a)(4)(ii).

225Va. Code Ann. section 58.1-402(B)(9)(a)(4)(iii).226Va. Code Ann. section 58.1-402(B)(9)(a)(4)(iv).227Va. Code Ann. section 58.1-402(B)(9)(b).228Va. Code Ann. section 58.1-402(B)(9)(b).229Va. Code Ann. section 58.1-402(B)(9)(b).230Va. Code Ann. section 58.1-402(B)(9)(c).

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Documents

Exceptions to Interest Addback Requirements for Related ... · Exceptions to Interest Addback Requirements for Related-Member Interest and Intangible Expenses by Michael A. Guariglia,